4 ETF trends show cautious optimism for 2018

Recent flows suggest that investors are priming for a rougher but hopeful future. Here’s where the money went and why.

“A clock in a thunderstorm.” That’s how Robert Louis Stevenson described those fortunate, unflappable souls who move through life’s ups and downs at their own pace, without getting rattled by the behavior of others.

That picture of equanimity could also be applied to exchange traded funds, which provided a steady hand as markets hit rough seas in the past quarter: mammoth inflows in January, followed by the steepest stock corrections since 2008. Yet no matter which direction markets moved, ETFs allowed U.S. investors to transact in them seamlessly and efficiently. The week of February 5th, over $1 trillion of ETF shares traded hands with no service disruptions, according to Bloomberg. That’s millions of buyers and sellers meeting on exchange, essentially canceling out each other’s trades.

In other words, prices went down, but the ETF structure functioned beautifully.

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And while stock and bond prices generally ended the quarter in negative territory, flows into ETFs continued to tick higher, reaching close to $60 billion in the U.S. and $128 billion globally (Bloomberg). It was a clear demonstration of investors’ faith in the versatility and sheer usefulness of ETFs.

A glass half full, mostly

Drilling down a bit, ETF flow patterns also shed some light on how U.S. investors are thinking about risks and opportunities and positioning their portfolios for the future. Broadly speaking, these moves acknowledge that 2018 will likely be quite different from 2017. They show that investors are still bullish, but they’re also keeping an eye out for potential “thunderstorms,” be they rising rates, inflation or geopolitical risks.

The cautiously optimistic outlook was expressed in four key investment trends in the first quarter:

  1. Stock investors are focused on diversification and quality. The quarter saw strong investments in emerging and international developed markets ETFs, as people sought to both broaden their opportunity set and reduce over-concentration in U.S. stocks. At the same time, investors abandoned defensive stocks (think utilities, telecom and other typical high-yielders), which can be sensitive to inflation and rising rates. They turned instead to higher quality, dividend-growth ETFs—companies with sound balance sheets and likely to keep up with inflation.
  2. Bonds are a defense game, where shorter and fatter make sense. As rates rise, investors have turned to shorter-maturity bond ETFs, which currently look attractive from a risk/return perspective: potential for a nice jump in yield and a fatter cushion against price declines than longer-term bonds. Flows to TIPS and floating rates ETFs have also increased, as a buffer against inflation.

ST bond flows

  1. From a factor perspective, investors are firmly risk-on. The flows into smart beta ETFs tilted heavily toward the momentum factor and away from minimum volatility. Given the recent volatility, this trend may seem surprising, but in fact so-called defense sectors have typically fared better during contractionary periods. Sometimes offense is the best defense.
  2. ETFs are becoming a long-term vehicle of choice. Broad market ETFs saw net positive flows across asset classes—not just to developed market stocks and bonds, but notably to broad emerging markets stocks, which saw more than $22 billion added in the quarter. The message here is clear: more investors than ever are using ETFs to progress toward their most important goals.

While ETF flows have slowed slightly from the previous year, I believe it is almost certainly a temporary loss of speed, the result of some investors moving to the sidelines as the market cycle turns. Big structural changes—consumer demand for value and control, the rise of fee-based advice, financial regulation—all provide a means for ETFs to continue to grow, bigger and faster than ever, no matter what the weather.

Watch this video to learn how ETFs work.

Martin Small is the Head of U.S. iShares and a regular contributor to The Blog

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