September capped a strong quarter for asset class returns and ETF flows. Investors poured $36 billion into ETFs during the month, bringing the quarter to more than $89 billion in net flows, narrowly outpacing the third quarter of 2017, which saw over $86 billion in net flows. At this time in 2017, ETFs had brought in a record $333 billion in net new flows. Although the strong third quarter brought us closer to that amount, so far in 2018, we have amassed $212 billion in net new flows, putting us roughly 37% behind 2017’s pace.
Growth Outperforms, but Investors Seek Value ETFs
The second quarter earnings season featured some performance dichotomy around certain high-growth stocks, but that hasn’t slowed the overall “growth over value” trend. A flattening yield curve continues to underpin the structural engine driving growth equities. Long-end yields failing to keep pace with short-end moves upward show how the bond market is skeptical of the long-term growth story. Equity investors are displaying similar skepticism, bidding up any meaningful growth stocks.
The third quarter certainly reminded us of that tailwind–growth outperformed value by nearly 4%, widening the performance spread to over 13% in favor of growth. Third quarter ETF style flows have deviated from this performance backdrop, as flows skewed toward value funds by nearly $5 billion relative to growth, perhaps an investor cry for less rich equities amid a 10-year bull market. Participants were burned by this “reversal anticipation” in late 2017 when they similarly placed more than $5 billion in value over growth only to see growth outperform value by more than 5% during the first three months of 2018.
Small Cap Trade Losing Steam
After a brief period of outperforming large caps with dollar strength, small caps underperformed larger companies by nearly 4% during the third quarter, losing $25 billion in net flows in the process. This is to be expected, as standard asset allocation calls for greater weight to large caps than small caps given their historically more stable returns. However, when the VIX spiked earlier this year, investors found shelter in small caps, as both flows and relative performance depict in Exhibit 3. In fact, net flows into small caps outpaced large-cap ETF flows, quite the rarity in the ETF marketplace. This trend continued into the middle of the year, as the NFIB Small Business Optimism Index hit its highest level in 45 years during August, a display of small business confidence amid swift fiscal expansion. However, performance speaks louder than optimism, and as the small cap “sugar rush” has tempered more recently, funds flowed back into large caps during the third quarter.
Healthcare Hits a Record Three-Month Inflow as Investors Rotate
When the growth trade was losing steam toward the end of the first half of the year, technology shares were a topic of conversation. The market’s leaders have seen both balance sheet and shareholders’ equity gains over the past few years, but new data privacy regulations combined with already lofty valuations have investors speculating on future returns. Combine this with a macro backdrop that still favors growth equities, and investors have rotated to other industries to fulfill that growth goal. Healthcare is one of those sectors–investors placed a record $6.7 billion into healthcare ETFs over the past three months. This is perhaps not surprising given the sector was up nearly 15% for the quarter. The second-best performing sector, Industrials, also posted double-digit gains, yet participants were more reluctant to place industry bets in this area, perhaps because of the threat of continued tariff rhetoric and potential logistical disruptions to these companies.
Emerging Market Fixed Income Continues to Underperform, but Investors Keep the Faith
High yield (HY) spreads have continued to narrow amid relative outperformance versus investment grade, while USD strength has punished certain emerging market (EM) economies with extreme levels of USD-denominated debt. Thus, while HY credit spreads have tightened, EM credit spreads have gone the other way, and the spread between the two has contracted to some of the narrowest levels we’ve seen. However, in a sign of contrarianism, investors placed $700 million into EM fixed income last month and more than $2 billion into EM fixed income for the quarter, their collective eye on a potential value opportunity.
An Eye on the Fourth Quarter and Tax-Fueled Trading
With three months to go, ETF flows are still nearly $100 billion off last year’s pace. It’s safe to say that flows are not going to hit the record levels that the industry enjoyed last year. Still, the third quarter certainly showed that ETF investors are capable of investing with the velocity that we witnessed last year, even if it hasn’t been consistent year-round. The fourth quarter tends to see some of the chunkiest ETF flows as planners utilize the ETF vehicle for tactical movements to shelter portfolios from unwanted capital gains. In fact, over the past five years, fourth quarter ETF net new flows on average made up 39% of total flows for the year. In 2014, the fourth quarter accounted for more than 50% of net flows during the entire year. Let’s watch and see what this quarter has in store for the ETF marketplace.
The MSCI® EAFE Index is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI EAFE Index consists of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.
The S&P 500® Index is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries within the U.S. economy. Index includes reinvestment of dividends but does not include fees, expenses, or taxes.
The Bloomberg Barclays Global Aggregate Bond Index provides a broad-based measure of global investment grade fixed-rate debt markets. The index is comprised of several other Barclays indexes that measure fixed income performance of regions around the world while hedging the currency back to the US dollar.
The Russell 1000® Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the Russell 3000 Index.
The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The indexes are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict performance of the Fund. Past performance does not guarantee future results.
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