ETF perspectives: Q2 markets moved higher, but inflationary uncertainty persists

Industry assets and cash flow

The S&P 500 Index moved 4.3% higher in the second quarter as the U.S. economy added more jobs, while the bond markets idled a bit, rising 0.08% amid mixed news on inflation.¹ Additionally, the unemployment rate fell below 4%, while the core Consumer Price Index rose 0.2% month-over-month in May and edged 0.1% higher in June.² Still, the Federal Reserve remains committed to delaying a rate cut amid strong labor market conditions, as well as concerns that inflationary pressures may persist.

Regarding flow trends, ETF investors reacted to these market conditions with some consistent behaviors, plus a few new ones. Equity ETF inflows totaled $141.8 billion, with large-blend and large-growth ETFs consistently leading the pack. Meanwhile, foreign large-blend ETFs saw more inflows, a possible reflection of investor preference for greater diversification amid the growing concentration in some large U.S. companies. Fixed income inflows were $68.5 billion, with ultrashort ETFs representing the most popular asset class and intermediate categories generating significant interest as well, in a sign that investors could be recalibrating their duration. High-yield ETF flows rose in May, while corporate bond ETFs saw limited inflows at a time of historically tight spreads.

Equities spotlight

Rising allocations to international equity ETFs

Flows into international equity ETFs appear to be accelerating so far in 2024, suggesting U.S. investors may be growing concerned with the potential risks of home bias and focusing too much on a U.S stock market that has now climbed roughly 2.5 times as high as its COVID-19-era low in March 2020.³ International equity flows of $57 billion through June of this year, while well short of the $199 billion pulled in by U.S. equity strategies, notably exceed 2023’s first-half international equity flows of $52 billion.⁴

With these inflows in mind, it’s a good time to take measure of why such diversification may be critical to long-term investing success:

• Concentration risk: Focusing too much on one geographic area or investment sector introduces the risk of a bad apple spoiling the barrel. Put another way, diversifying holdings can potentially introduce a buffer into portfolios that can offset losses. In recent years, U.S. equities have become top-heavy with some of the more conspicuous tech names, the so-called “Magnificent 7.”⁵ Almost 30% of Vanguard Total Stock Market ETF (VTI) consists of these holdings. Lowering VTI exposure to 60% and adding 40% of international exposure in the form of Vanguard Total International Stock ETF (VXUS) would cut this concentration to 17%.
• Volatility reduction: Our research of investment portfolios over the past 10 years shows that an allocation to international stocks ranging from 20% to 50% of total equity holdings can reduce portfolio volatility by as much as 5%.
• Benchmark allocations: As a reality check, it’s worth remembering that many global equity benchmarks, including the FTSE Global All Cap Index on which Vanguard Total World Stock ETF (VT) is based, have about 62% exposure to U.S. stocks.⁶ With 76% of equity ETF flows favoring U.S. stocks the past three years, according to Morningstar, Inc., investors could still be well shy of global market allocations. Such benchmark allocations are based on careful research of each region’s contributions to global GDP, and the market capitalization of the securities in each of those regions. Deviations from the benchmark may lead to unwanted deviations in performance.

Fixed income spotlight

Reexamining bond ETF metrics post rate hikes

As the market starts to consider a changing environment where yields begin to fall, the topic of “locking in rates” has grown in focus. Ten-year Treasuries are now yielding 4.36%, while 2-year notes now yield 4.71%, compared with 1.52% and 0.73%, respectively, at the end of 2021.7 In view of these increases, some advisors are considering adding exposure to fixed income ETFs in their portfolios.

Several yield metrics are quoted for bond ETFs, and investors might not always be able to map relevant bond-fund metrics to what they’re hearing on CNBC or seeing in The Wall Street Journal—as many financial media outlets tend to focus on changes in the federal funds rate, Treasury yields, or 30-year mortgage rates.

SEC yield versus distribution yield

Two of the most commonly consulted metrics for bond ETFs are:

• SEC yield: Reflects the average yield to maturity experienced in a portfolio over the past 30 days.
• Distribution yield: Refers to the actual income that the fund distributes.

Due to the relatively recent 30-day time frame, SEC yields adjust quickly to changes in market rates and can be a timely representation for the yield to maturity on the underlying portfolio of bonds. On the other hand, distribution yield is based on the yield of a specific security at the time the fund purchased the bond. Because ETFs can hold bonds for many years, the distribution yield can be slow to adjust to benchmark yield changes.

With any bond ETF, it’s important to remember that income and price both play a part in the return. So an investor isn’t necessarily missing out on return if an ETF has a low distribution yield relative to its SEC yield, because more return may come from rising bond prices.

As illustrated in the chart below, the SEC yield for “ETF A” was quick to adjust to the sharp rise in interest rates beginning in late 2021 and continuing through early 2023, while the distribution yield has increased more gradually. When trying to understand how quickly these two metrics will converge for an ETF, it’s important to consider portfolio turnover. Higher portfolio turnover means that bonds with updated yields get recycled into the portfolio more quickly, which causes distribution yield to adjust more rapidly. Should rates fall, SEC yields will decline more quickly than distribution yields because it will take time for bonds to cycle out of the portfolio.

So how does this relate to locking in rates? When you buy an ETF, you are buying a slice of the underlying bonds in the portfolio at a particular yield and price point. While yields can move from there, the SEC yield at your entry point can be a strong predicter for an ETF’s total return over its duration. The actual income payments on a product will move gradually over time, but investors who allocate today are essentially “locking in” the total return profile of current interest rates.

Industry trends and insights

Total cost of active ETF ownership

While our recent examination of the total costs of ETF ownership focused on index ETFs, accelerating interest in active ETFs compels us to provide a similar perspective on them. Active ETFs, like index ETFs, have been on a trajectory of declining costs as their popularity has expanded. If index ETFs have “become adults” after more than 30 years of existence, active ETFs might be considered more like teens full of potential for growth.

Expense ratios

Active ETFs have different costs than index ETFs. For instance, the cost of active managers—who can possibly deploy a strategy that’s difficult to replicate or develop the secret sauce for a given ETF to outperform a related benchmark—will always fetch a premium over an index ETF targeting a similar slice of the investment universe. Also, active managers who execute more frequent trades would require larger teams, resulting in added costs.

But ETF investors are still cost-conscious, and active ETFs with lower expense ratios have generated the most interest. As a result, the average asset-weighted expense ratio for active ETFs has fallen from about 50 basis points (bps) in 2019 to less than 40 bps today. In 2009, when index ETFs were about 15 years old—the same age as active ETFs today—their average asset-weighted expense ratio was 57 bps. Today, they’re also less than 40 bps.⁸ This suggests that as use of active ETFs increases, their average expense ratio may continue to decline as well.

Volumes and spreads

As assets in active ETFs have increased, liquidity has also increased and bid-ask spreads have tightened. The higher assets climb, the more that will translate into greater liquidity and tighter bid-ask spreads, as was the case for index ETFs. With some of the top active ETFs trading more in the secondary market, their spreads have trended down—with the median spread moving from 0.40% a decade ago to 0.18% at the end of 2024’s second quarter.⁹

As active ETFs keep growing, the extent to which spreads continue to tighten will depend largely on how much an active ETF differs from its index, or how well market makers can create a hedging portfolio on an active ETF’s basket that has less transparency. But as volume continues to grow, and as market makers hold ETF shares in their inventory for less time, the lower spreads are likely to go.

Premium and discount volatility

Another significant consideration is the volatility of active ETF premiums and discounts. While the same factors influence price for both active and index ETFs, active ETFs will likely be more impacted by supply-and-demand dynamics based on strategy, manager, or market trends.

Fair value of the ETF’s holdings is an important factor as well. Assuming active ETFs have more concentrated holdings, one holding could have an outsized impact on an ETF’s premium or discount. Thus, each ETF should be evaluated separately on this dynamic. But the trend is positive for active ETFs as adoption increases, with volatility decreasing from 28 bps to 10 bps in the past 10 years.

The data are clear that the total costs of active ETF ownership are trending down as interest in active ETFs expands. It remains important for advisors to evaluate active ETFs on these parameters, but with different expectations compared to those regarding index ETFs. As always with active strategies, it’s paramount to assess each active ETF based on its potential to outperform a particular market segment or deliver a specialized strategy.

Taking measure of ETF options

ETFs with option overlays have been around for more than 15 years. And as the U.S. market continues to evolve, use of ETF options is increasing in multiple ways. One component is an increase in the options contracts traded on ETFs, with ETF options volume rising 265% over the past five years.¹⁰ Additionally, we’re seeing increasing options use directly in ETFs, with nearly 17% of all active ETF inflows this year using options overlay strategies, including defined-outcome funds such as buffered products, and derivative income strategies.¹¹

While ETFs custom-built with options strategies are growing, so too are options on ETFs, in general, as advisors look to generate additional income through covered calls or the use of protective puts for downside protection. Currently, 90% of Vanguard ETFs have options trading capabilities for ETF investors who are looking for that flexibility.

In fact, most ETFs have options chains available, and the longer a particular ETF has been around, the more likely it is to have options attached. It’s no surprise that the most liquid options chains are attached to the most popular indexes, including the S&P 500, the Nasdaq-100, and the Russell 2000.

The presence of ETF options contributes to overall liquidity of the underlying ETFs. Given the rising activity in the space, here are a few points we’d urge advisors to keep in mind:

• Many of the core holdings that already exist in client portfolios likely have a direct option seeking to generate income through a covered call, or to hedge that exposure with a protective put. Only the newest Vanguard ETFs lack options. And over time, options chains may become available on the products that don’t yet have options. Additionally, weekly options are starting to emerge on some ETFs, providing more customizable strategies to tailor the duration of a hedge.
• Options are complex instruments that can entail significant risk if used without a proper understanding of the investment. For advisors considering more conservative options strategies such as covered calls, protective puts, and collars, these can often be deployed at a fraction of the cost by trading the options directly versus using a structured product.¹² As obvious as this may be, ETFs with options overlays have considerably higher expense ratios than the underlying ETFs on which they are based.
• Advisors keen to initiate an options overlay on top of Vanguard S&P 500 ETF (VOO), for example, may be hesitant to do so because of wider quoted spreads in the options contracts. It’s important to understand that an options quoted spread is often much wider than the effective spread where market makers may be willing to provide liquidity. By using a limit order within the quoted spread when trading options, investors can often minimize transaction costs, as shown in the trade example below.

1 Morningstar, Inc., as of June 30, 2024.

2 U.S. Bureau of Labor Statistics, as of July 11, 2024.3

3 Standard and Poor’s, from March 23, 2020, through July 16, 2024.

4 Morningstar, Inc., as of June 30, 2024.

5 The “Magnificent 7”—those companies at the center of the growth rally in recent years—are Alphabet Inc. (GOOG), Amazon.com, Inc. (AMZN), Apple Inc. (AAPL), Meta Platforms, Inc. (META), Microsoft Corp. (MSFT), NVIDIA Corp. (NVDA), and Tesla, Inc. (TSLA).

6 Vanguard, as of June 30, 2024.

7 Two-year real yield and 10-year real yield from U.S. Treasury’s Federal Reserve Economic Data online database, as of June 30, 2024.

8 Morningstar, Inc., as of May 31, 2024.

9 Bloomberg, as of May 31, 2024.

10 Bloomberg, and Morningstar, Inc., from January 2, 2019, through December 31, 2023.

11 Morningstar, Inc., as of June 30, 2024.

12 A collar is a multiple-option strategy involving the sale of a call option and the purchase of a put option. The strategy is meant for long-term holders of a security aiming to potentially profit from near-term volatility.

Notes:

• For more information about Vanguard funds or Vanguard ETFs, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

• Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
• Past performance is no guarantee of future results.

• All investing is subject to risk, which may result in loss of principal. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account.
• There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
• Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.
• Investments in bonds are subject to interest rate, credit, and inflation risk.
• Investments in bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.
• Diversification does not ensure a profit or protect against a loss.
• U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.
• Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
• CFA® is a registered trademark owned by CFA Institute.
• Options are a leveraged investment and are not suitable for every investor. Options involve risk, including the possibility that you could lose more money than you invest. Before buying or selling options, you must receive a copy of Characteristics and Risks of Standardized Options issued by OCC. A copy of this booklet is available at theocc.com. It may also be obtained from your broker, any exchange on which options are traded, or by contacting OCC at 125 S. Franklin Street, Suite 1200, Chicago, IL 60606 (888-678-4667 or 888-OPTIONS). The booklet contains information on options issued by OCC. It is intended for educational purposes. No statement in the booklet should be construed as a recommendation to buy or sell a security or to provide investment advice. For further assistance, please call The Options Industry Council (OIC) helpline at 888-OPTIONS or visit optionseducation.org for more information. The OIC can provide you with balanced options education and tools to assist you with your options questions and trading.