U.S. Fixed Income the Lone Bright Spot
Even with rates rising, investors added $1.7 billion to fixed income ETFs. Money flowed in to U.S. bonds and out of international bonds. In particular, emerging market debt saw outflows of nearly $1.2 billion. Among the smaller ETF categories, results were mixed as alternative and currency ETFs saw $183 million in outflows, while asset allocation, commodity, and derivative ETFs took in a combined $199 million.
International Equity ETFs See Inflows Amid U.S. Outflows
International equity ETF flows stood out in February, as broad-based, non-U.S. developed and emerging market ETFs took in new money. With international equity markets underperforming U.S. counterparts year to date, these flows may be a sign of asset allocation moves. Investor flows have a tendency to chase performance, but this didn’t hold up last month, when U.S. equity ETFs bled assets, while international flows held steady.
Spying on SPY
The main driver of both January’s inflows and February’s outflows was the capital market community’s use of the world’s largest ETF and most liquid listed security, the SPDR S&P 500 ETF (SPY). While much has been written about SPY flows, many do not appreciate SPY’s role in helping the trading community at large manage liquidity needs when hedging their portfolios based on client demand. As investors increased their exposure to the market via call options, market makers were able to efficiently hedge their positions by buying shares of SPY. As market participants began to aggressively decrease their long exposure, market makers unwound their own positions in SPY. Despite the market experiencing its first down month since October 2016, year-to-date inflows to domestic equity ex-SPY demonstrate continued faith in the asset class as a core holding.
Another Month of High Yield Outflows
Fixed income ETF flows were positive in February despite continued outflows in credit products, in particular, high yield bonds. The credit ETF market has been by hit by a wave of selling, primarily as a result of recent heightened equity and rate volatility, in addition to marginal credit market underperformance. It’s worth noting that mutual funds and ETFs together hold only 21.5% of the entire U.S. investment grade and high yield bond market, and ETFs alone hold only 2.9% of U.S. investment grade corporate bond assets. The takeaway is that the potential impact of ETF investor redemptions on the underlying market remains limited.1
From a duration perspective, investors preferred ultra-short and short duration ETFs at the expense of those with an intermediate or long-term focus. With inflation showing rumblings of strength and fiscal policy firmly in expansionary territory, interest rates have been on the rise. ETF participants have reacted in-line, shortening duration significantly during the month of February. With current Treasury yields near recent highs, it will be interesting to monitor rate moves and subsequent flows along the curve from here.
Strong ETF Flows Likely to Continue Despite February Weakness
Positioning by market makers drove headline-dominating inflows in January and outflows in February. However, outside of products used primarily by traders, ETF inflows remained firmly positive. Recent trends, such as flows into non-U.S. strategies, have continued, while choppy high yield flows have increasingly turned into a one-way trade of outflows. As we continue through 2018, it is our opinion that financial planners will continue to look toward ETFs as portfolio building blocks, putting a steady tailwind behind continued ETF flow strength.
- ^Source: Bank of America Merrill Lynch, Credit Market Strategist, “Cash is King”, February 16, 2018.
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