After a strong April and May, June saw ETF industry flows slow, as $1.7 billion came out the door. Midway through the year, ETFs have brought in $120 billion of net flows. While sizable, that volume is still underwhelming when compared with last year’s record ETF flows. In fact, we are more than 50% behind last year’s pace of nearly $250 billion net new flows, tacked on through the first half of 2017.

A Tale of Two Halves

The market environment this year has changed rather drastically from what it was last year. While international equities were up nearly 14% in the first six months of 2017, this year’s trade tensions, a stronger U.S. dollar, and slowing global economic momentum have this asset class down nearly 3% for the first half of the year -- a near 17% difference in returns! In fact, all categories, except international fixed income, are showing significantly different performance when compared with last year’s first half. Commodities are the one major asset class performing much better through the first half of the year. In fact, they are enjoying their best returns since 2002. But you wouldn’t know that by looking at the volume of investments in commodity-focused ETFs, as they have experienced a paltry $1 billion in net new flows so far this year.

Exhibit 1: U.S. Equity and Fixed Income Lead While International Equity Slows

Investors Find Reprieve in Small Caps

Global trade tensions have brought heightened geopolitical risk across markets, while at the same time U.S. economic data have continued to come in above trend. In combination, these two forces have driven investors to seek investments in businesses that operate primarily within the United States, as opposed to multinationals with a global reach. Small caps, whose operations are generally more U.S.- focused, have benefitted and enjoyed significant flows at the expense of large caps, as shown in Exhibit 2. To further illustrate how different circumstances are this year, Exhibit 2 also shows the flow data in relation to the premium that the Russell 2000 Volatility Index (CBOE: RVX) typically trades at relative to the S&P 500 Volatility Index (CBOE: VIX). Small caps normally trade at a “premium volatility” relative to large caps, but earlier this year, volatility spiked, specifically within large-caps, while small caps offered unusual defensiveness. Noticing this, investors have added significantly to small cap ETFs this year. In fact, the asset flows into small cap ETFs have outpaced those into large caps for three of the past six months. That is a rarity because of both the sheer size of large cap ETFs and the fact that large caps constitute a much larger portion of most client portfolios than small caps do.

Exhibit 2: Investors Have Flocked to Small-Cap ETFs as Small-Cap Volatility Has Come Down Relative to Large Caps

Energy Got No Love

Oil prices in 2018 have rallied to a three-and-a-half year high, with global demand rising and concerns about supply coming from traditionally top producers such as Venezuela and Libya. These developments have produced a long-awaited rebound in energy stocks, as the energy companies in the S&P 500 delivered average returns of 10% in 2018, making them the best-performing sector. ETF investors don’t seem overly impressed, as there has just been about $2 billion in energy equity net new flows. That volume pales in comparison with Technology, the next best-performing sector on average, which has had nearly $10 billion in net new flows for the year. Perhaps investors are more interested in playing the commodity uptick trend within Basic Materials ETFs, which have gathered a bit more interest at $3 billion of net new flows.

Exhibit 3: Energy Leads But Gets No Love, While Materials Gather Flows Despite Lackluster Returns

High Yield ETF Flows Sending Warning Signs?

Corporate high yield has continued to outperform this year, as credit spreads have narrowed to some of the tightest levels we’ve seen. Even with all the current geopolitical tension, high yield bonds this year still seem to be adhering to their historical pattern of doing well during periods of rising rates. When rates rise, the higher coupons that junk bonds offer can help them weather the storm of falling fixed income prices better than lower-coupon investment-grade bonds. However, market participants have redeemed a net $5 billion from high yield fixed income this year in an apparent effort to lower their risk exposure. With the performance and flows of this asset class diverging, we will have to see what transpires in the second half of the year to determine whether these outflows were warranted or premature.

Exhibit 4: High Yield Credit Spreads Narrow, yet Investors Are Redeeming High Yield ETFs

Meanwhile on the duration front, investors have pounded the short end of the curve and moved into ultra-short ETFs (one year or less) at a record pace. Last year was a record for the ultra-short category at $11 billion in net inflows, but this year’s flows are on pace to blow that figure out of the water, as there has already been nearly $19 billion of net new flows through the year’s midway point. Exhibit 5 overlays ultra-short ETF flows with the four-week Treasury yield to show how investors have locked in a strong income stream moving forward, and how the fixed income community is seeking refuge from duration risk in general as the trajectory is squarely pointing upwards on rates.

Exhibit 5: As Short Rates Rise Dramatically, Investors Have Piled Money into Ultra-Short Duration ETFs

What Will the Rest of 2018 Bring?

So far in 2018, volatility has crept back into markets, and ETF flows reflect that. Investors have been following these trends and reducing their risk exposure, slowing flows this year down considerably in relation to what they were in last year’s rather sanguine, Goldilocks market environment. This year, new market themes have evolved that have an implication for ETF investors. Global trade tensions have increased the demand for small caps. Rising interest rates have focused investors’ attention on duration risk, causing record inflows into ultra-short duration bond funds. At this point, ETF flows are well off the 2017 record pace, but “it ain’t over ’til it’s over.” While a pattern for the year seems to have taken shape, with six months remaining, there is still plenty of time for new trends to emerge that will determine the type of year 2018 proves to be for ETF flows.