ETF perspectives: Gifts in the form of comfy, familiar flows
February 20, 2024
February 20, 2024
Each quarter, we bring you the latest ETF trends and insights from our investment experts to help you address issues that may affect your clients’ portfolios.
Head of Index Fixed Income Product
Head of Index Equity Product
Senior ETF Capital Markets Specialist
Industry assets and cash flow
ETF assets rebounded on the back of strong markets to close 2023, defying some predictions that a slowdown would materialize in the U.S. Investors plowed forward, with equities and fixed income both ending the year on strong notes after a dismal 2022. The surge of cash into ETFs, which helped lift total assets to more than $8 trillion, particularly benefited equities as investors kept it simple and stuck to broad-based strategies.
Following a muted Q3 that saw ETF assets decline due to falling markets, ETF industry assets rose 13.2% in the fourth quarter to $8.1 trillion, as near-record quarterly inflows of $266 billion were boosted by $682 billion of market appreciation. The inflows and market gains were fueled by comments from the Federal Reserve signaling that inflationary pressure is abating. Growth may be slowing, but it remains positive. All eyes are now on the labor market and how it holds up in a higher-rate environment. The employment picture currently remains robust, which has helped boost risk appetite, asset prices, and interest in ETFs.
Total ETF flows in the fourth quarter were exceedingly strong, easily eclipsing the slog in 2023’s first three quarters and topping all historical quarterly flows save for the amount recorded in Q4 2021, which remains a record. Flows accelerated significantly in December as investors tuned into signs of declining inflationary pressures and made late-year tax-related moves that favored ETFs. Equity strategies pulled in $195 billion as markets rose by more than 26%.
Slowing rate hikes among developed markets central banks—based on signs that inflationary pressure is declining, plus economic data showing continued growth and steady unemployment—helped encourage risk-on sentiment among both equity and fixed income investors.
Equity ETF flows may have stolen the limelight, but fixed income ETFs generated interest in their own right. Fixed income ETFs gathered $69.1 billion amid signs that global markets are transitioning away from the zero-interest-rate policies of years past and the global economy may be settling into this higher-rate environment.
Unlike with equity flows, which were generally more concentrated in the biggest tickers, investors continued to pick their spots in fixed income. They doubled down on longer-dated bond ETFs in a sign they may be anticipating the end of the rate-hike cycle and potentially even monetary policy easing in 2024.
U.S.-focused equities again dominated, garnering 86% of the $195 billion in total Q4 equity inflows. Strategies that track the Standard & Poor’s 500 Index accounted for much of those inflows, totaling $79.7 billion in the quarter and $137.8 billion for the year. This trend was largely expected due to tax-loss harvesting activity, but the flows were higher than normal.
The Q4 popularity of growth ETFs also reflected a risk-on sentiment that first appeared in Q3. Investors funneled more than $12.5 billion into broad growth ETFs, particularly those that track the Nasdaq-100 Index, the Russell 1000 Growth Index, and the CRSP US Large Cap Growth Index.
U.S. equity flows may have remained relatively heavy, but a strong push into international equity ETFs in December manifested as well in a variation on the strong year-end flows that have become a seasonal characteristic in the ETF world.
The S&P 500 Index rebounded by more than 26% in 2023 after falling more than 18% in 2022. The rebound helped fuel interest in S&P 500 ETFs, particularly during the second half of the year. But how did these developments compare to prior years?
The top four pure S&P 500 ETFs—Vanguard S&P 500 ETF (VOO), iShares Core S&P 500 ETF (IVV), SPDR S&P 500 ETF Trust (SPY), SPDR Portfolio S&P 500 ETF (SPLG)—collectively gathered 47% of all equity inflows in 2023, the highest percentage since 2012. The interest in these strategies might reflect a fear of missing out on the 2023 rally and/or a short-term tactic to equitize cash before allocating more strategically in 2024. This approach, which could involve a deviation from long-term allocations, should be entertained only with the greatest of caution. It also highlights why investors should beware of exiting the market following downturns, as it increases the risk of missing subsequent rallies.
Taxable fixed income
Fixed income ETF inflows totaled $69.1 billion in the fourth quarter, as investors showed greater appetite for core active strategies and also doubled down on buying debt further out along the yield curve. Core strategies, which received $15 billion last quarter, are enjoying an appetite for active management. In the core and core-plus categories, four of the top 10 ETFs by flows were active. Flows into long-dated debt were concentrated in government debt, a strategy that has attracted increasing interest on hopes that the Fed will implement rate cuts in 2024. These hopes led to flows into investment-grade credit, with a greater concentration of interest in intermediate-term debt than in previous quarters. Investors went as far as taking on more credit risk, with flows into high-yield turning positive in the fourth quarter.
Municipal fixed income
Inflows into municipal bond ETFs nearly doubled from levels in both the second and third quarters. Most of the new investments, as was the case earlier in the year, were concentrated in total muni strategies that hold bonds across the muni yield curve.
During the previous regime of low interest rates, investors moved gingerly out along the curve with short-duration ETFs. But in the wake of 2022’s big rate hikes, flows in 2023 started shifting into intermediate-term and long-duration debt. The move to use ETFs to increase duration shared the stage with a trend from earlier in the year of investors favoring ultra-short bond ETFs. The result is something of a barbell type of approach to bond allocations: ultra-short duration for liquidity or risk mitigation, and longer duration for expressing outlooks on future rates.
With a sizable amount of uninvested cash remaining on the sidelines, questions persist about which parts of the investment universe these unallocated assets may soon call home. The move to increase duration suggests, as noted, that investors may be in the process of reevaluating where to reallocate what remains of hefty holdings of cash and other shorter-dated fixed income instruments. More economic data and how the Fed responds to those data will be crucial in determining such allocation changes.
Industry trends and insights
Even as investors sought the comfort of broad strategies, other trends stuck out, namely growing interest in active ETFs and defined-maturity strategies (DMFs). We look at those trends more closely below. Vanguard itself joined the active push, launching our Core Bond ETF (VCRB) and Core-Plus Bond ETF (VPLS) in December.
Investors can manage portfolio duration in a number of potentially effective ways. These include adding specific bond ETFs to preexisting bond ladders. Such an approach helps manage liquidity and refine or diversify risk. It also potentially smoothes reinvestment of proceeds from individual bonds as they pay coupons or mature.
Additionally, investors can combine several ETFs to manage duration. Traditional perpetual bond ETFs often have cost and structural advantages over both DMFs and individual bonds. They tend to have higher liquidity too, which helps investors adjust more readily to emergency needs or otherwise unexpected factors. Using perpetual bond ETFs enables investors to swiftly and affordably rebalance exposures as markets shift and risk appetites change.
In the realm of bond ETFs, core-plus led all fixed income categories, with $11.6 billion in inflows. This is a category tailor-made for active management, in the sense that it provides investors with access to manager expertise with the discretion to explore opportunities across the vast fixed income market. Managers potentially have the knowledge to determine when and how to lean in and out of credit and how to position for changes in interest rates.
While index strategies garnered the lion’s share of the ultra-short bond category, active strategies also pulled in fresh assets, though fewer than in 2022. Within the core and core-plus categories, four of the top 10 ETFs in terms of flows were active strategies. The core portion of the active bond investing universe, like core-plus, also lends itself to leveraging manager expertise but with less comparative risk.
In December, Vanguard launched two active bond ETFs, Vanguard Core Bond ETF (VCRB) and Vanguard Core-Plus Bond ETF (VPLS). Both ETFs combine the advantages of low-cost active management and smart risk-taking to help generate returns and yield without taking undue risk. They’re managed by a team of deep, specialized experts who seek to find alpha opportunities in all market conditions.
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