ETF perspectives: Rising markets and inflows lift ETF assets to a record high

ETF industry assets rose 8.79% in the first quarter to $8.87 trillion as inflows of $195 billion were boosted by $522 billion worth of market appreciation. The inflows and market gains came amid shifting perceptions of when the Fed might start easing credit costs.

Q1 inflows hold strong as rates look to stay higher for longer

Whereas market expectations at the end of 2023 centered on initial rate cuts coming by the end of the first quarter, Fed comments on concerns about possibly sticky inflation and labor market data have shifted expectations for a potential first cut to come later this year. The economy continues to generate robust job gains, which in turn have fueled continuing stock market gains.

Q1 equity flows, focused increasingly on large-cap growth, totaled $137 billion—about on par with recent historical patterns. Equity markets rose 10% in the quarter. And despite that, many of the rising stocks in the large-cap growth category may retain valuations—such as price/earnings ratios—that are consistent with historical patterns. We’ll look more closely at this subject in this report.

The persistence of risk-on sentiment in equity markets was fueled by economic data showing continued growth and a steady labor market. Upward blips in consumer-inflation readings for February and March gave pause, but those two data points remain for now just that—two data points. The market seems to be indicating that its focus will remain on each inflation report until a new trend is clearly discernible.

The renewed sense that rates may remain higher for longer has overshadowed fixed income allocation decisions, and active strategies are garnering an increasing share of the inflows. Q1 flows into fixed income ETFs totaled $49.9 billion, with new flows concentrating on the intermediate part of the yield curve. Those flows were almost 28% lower than the $69.1 billion in flows during 2023’s fourth quarter.

Equity ETFs

Equities accounted for about two-thirds of total Q1 ETF inflows, and almost 70% of the $137 billion in total equity flows were into U.S. equities. That percentage is slightly below the average quarterly equity flows over the last five years. International stocks, meanwhile, made up about 20% of total Q1 flows—a notable increase from about 11% in Q4 2023. Large-capitalization stocks were again heavy favorites, as they were in much of 2023; they made up 86% of all Q1 U.S. equity inflows, about the same as in the prior quarter.

The Standard & Poor’s 500 Index reached several record highs throughout Q1, ending the period about 10% higher. Q1 equity market gains were concentrated in large-cap ETFs, and in technology in particular, so we’ve looked at what’s going on with valuations in the large-cap realm.
 

Spotlight on large-cap growth ETFs

Our analysis of advisor portfolios suggests that large-cap growth is the most underowned segment of the equities market by 12 percentage points.¹ This may come as a surprise, because most of the S&P 500’s roughly 10% gains for Q1 were in large-cap growth stocks, including the “Magnificent Seven.”²

Although there’s some evidence of Mag 7 “turmoil,” there’s also a silver lining in their price/earnings (P/E) ratios, which stayed grounded as of year-end 2023 despite sizable gains in stock prices.

To be sure, the prices of some growth stocks, notably Tesla’s, have in recent years outrun their earnings. But a look at P/E ratios of the Mag 7 over the past two years suggests that earnings are keeping pace with share prices. For example, Nvidia—the stock at the center of the AI-focused investment trend—saw the largest year-over-year earnings growth, increasing nearly sevenfold to $11.93 per share in 2023, from $1.74 per share in 2022.

As it relates back to the underweight in large-cap stocks, this is likely a result of using more active, small-cap, factor-weighted, or equal-weighted products, which can lead to tilts away from benchmark exposures. But while some investors may be apprehensive about the large-cap growth category, there’s solace in the recent growth being sustained by earnings growth as well.
 

Fixed Income ETFs

Taxable fixed income

Fixed income ETF inflows totaled $49.9 billion in the first quarter, with intermediate-term strategies—both government and credit—attracting about 60% of those. Flows into government long-dated debt tapered off significantly from previous quarters, as long-dated yields remain elevated and their outlook uncertain. Interest in long-dated credit faded compared with the prior quarter. Because it appears that rates may remain higher for longer, further allocations to longer-dated bond ETFs may be on hold until clearer signs emerge that the Fed is really about to begin credit loosening. On the other end of the yield curve, outflows from short-term bonds are starting to slow. More notably, investors are returning to familiar active ETFs to regain exposure to short-dated credit ETFs in particular. The spotlight section that follows examines this topic in greater detail.

Municipal fixed income

Inflows into municipal bond ETFs slowed considerably from 2023’s fourth quarter. Outflows were concentrated in longer-dated strategies, while California-specific strategies garnered most of the inflows—a sign that investors may be seeking more tailored muni exposure.
 

Spotlight on fixed income

If one changing aspect of the expanding ETF industry is worth teasing out, it’s the ongoing emergence of actively managed ETFs, notably the intermediate (for example, core and core-plus) and ultra-short categories. Ultra-short was the largest active fixed income category (+$80.0 billion), while intermediate categories attracted more inflows (+$18.6 billion) over the 12 months ended March 31, 2024. Still, a large portion of active fixed income inflows in Q1 2024 were into ultra-short strategies, while passive ultra-short strategies saw outflows. Such active ETFs pulled in $4.4 billion in fresh assets, or about 24% of all active fixed income ETF flows.

This could mark an emerging reversal in the trend of 2023, when passive ultra-short bond ETFs dominated category flows overall. So far this year, these passive short-dated strategies have seen outflows.

But as we further peel back the ultra-short flows, what’s notable is that the passive ETFs primarily invest in government bonds, while the active ETFs give the manager more flexibility to pick among all available short-dated bonds, especially credit. And although overall flows into ultra-short ETFs appear muted on the surface (+$301 million), the shifts within it are large, with $4.4 billion moving to active strategies and $4.1 billion left passive. So we’re seeing more investors conservatively reaching for yields beyond government bonds again and looking to fund managers for the right opportunities to find that yield.

What to do with all that cash?

U.S. investors now hold about $6.0 trillion in money market funds, $1.1 trillion of which materialized in the last 18 months. That figure is relatively high historically and may be reflecting persistent anxiety in financial markets.

Cash allocations first spiked conspicuously by more than 50% during the 2007 to 2009 global financial crisis. They jumped an additional 25% at the time of the 2020 COVID-19 lockdowns, and a further 15% in the aftermath of the Fed’s aggressive credit-tightening campaign in 2022.³ The question now is: To what extent do historically large allocations to cash represent something of an opportunity cost to investors, and how far have investors distanced themselves from their strategic allocation?

With those questions in mind, we’ll look at three investor types and various asset allocation choices to assess what investors might be missing out on by possibly being overallocated to cash. We’ll put these investments in context with a cash equivalent that was yielding 5.33%.⁴ We’ve also mapped out how other allocations have fared compared with that cash allotment, and that comparison shows that investors who stayed put in equities or in a diversified portfolio—or even returned to diversified exposure in the last year—would have been better off than had they stayed in cash. Even as investors return to bonds, as we’ll show, they may benefit investors again and recover from previous losses.
 

Investor type #1: Stay close to home

While we’ve made the case for adding duration, some investors may have short-term goals or lower risk tolerances that make this less appealing. Staying overallocated to cash and below a strategic asset allocation to bonds presents risks too. Keeping duration low with short-term bonds will provide some benefit with yields in the range of cash, but unlike cash, they’ll provide upside potential if the Fed eventually cuts rates. If this is an investor’s goal, ETFs such as Vanguard Ultra-Short Bond ETF (VUSB) or Vanguard Short-Term Treasury ETF (VGSH) are two examples to consider.

Investor type #2: Be ready to recommit

For investors whose horizons are longer and who need to get back to their strategic allocations in bonds, this is where adding duration can add value. If the Fed cuts rates, money market distribution yields will be the first to drop, followed by short-term bonds. With intermediate- or longer-term bonds, higher yields can endure longer beyond rate cuts and, if yields fall, the added duration means their prices will appreciate more. By that logic, if the yield of Vanguard Intermediate-Term Treasury ETF (VGIT) were to fall, the price of the ETF might increase.

Investor type #3: Consider revisiting equities

We’ve generally observed that when investors get spooked, they fund their increase in cash by pulling from equities and distancing themselves from their long-term strategic allocation.⁵ There’s no one way to get back into stocks, as each investor is different. Investors who want the income to continue tend to turn to dividend stocks like those in Vanguard High Dividend Yield ETF (VYM). For those taking a broader, total-return approach, advisors tend to prefer using building blocks to achieve that. For this approach, we encourage them to use the building blocks within the same index family, whichever they choose. This will help ensure that investors have no unintended overlaps between their holdings, creating tilts they didn’t intend to make.

1. Vanguard analysis, based on 1,220 equity allocations observed in the period, with an average of six tickers per allocation sleeve, as of December 31, 2023.
2. The “Magnificent Seven”—those companies at the center of the growth rally of recent years—are Alphabet Inc. (GOOG/GOOGL); Amazon.com, Inc. (AMZN); Apple Inc. (AAPL); Meta Platforms, Inc. (META); Microsoft Corp. (MSFT); Nvidia Corp. (NVDA); and Tesla, Inc. (TSLA).
3. The latest spike in cash allocations is a direct result of the Fed’s 500 bps worth of rate hikes that mostly occurred in 2022 and that made short-term rates of cash-equivalent fixed income instruments relatively attractive.
4. The 5.33% cash-equivalent yield is that of the Treasury Bill Auction Average 1-Month Index as of March 31, 2024.
5. Sources: Vanguard Investment Advisory Research Center calculations, based on data from Morningstar, Inc., as of December 31, 2023. See the April 2024 Vanguard behavioral research article titled Fund industry’s asset mix offers encouraging sign.

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.
• Prices of mid- and small-cap stocks often fluctuate more than those of large company stocks. 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.
• Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
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