U.S.-listed ETFs had a banner year in 2017. The final tally of $466 billion of inflows in 2017 shattered 2016’s previous record by $177 billion! The industry now stands at $3.4 trillion in assets under management, but remains modest in size relative to the U.S. mutual fund industry’s $17.5 trillion under management.
With robust investor demand squarely in place and only intensifying, it is our opinion that ETF flows will set a new record in 2018, even if market volatility picks up, as many expect.
International Equities in Favor
The global recovery has renewed interest in international equities, and 2017 saw investors add more than $149 billion into ex-U.S. strategies, surpassing international equities’ 2015 record by almost $50 billion. Despite a strong showing for U.S. flows in the second half of the year, thanks to renewed confidence in the U.S. economy, international flows came out $5 billion ahead in 2017. As the U.S. continues to move later into the business cycle, it is our belief that investors will look more toward the international markets for an increased share of their equity exposure. Equity flows also favored U.S. large caps over small caps, and the financial sector.
Smart Beta Flows Didn’t Follow Performance
Smart beta ETF flows and performance paint two very different pictures. Value ETFs continue to take in the lion’s share of smart beta assets despite lagging performance for the year. It is our view that this may continue in 2018, as investors prepare themselves for an eventual rotation back to the value style, even if performance continues to lag like it did last year. The quality factor, defined by companies with high profitability and low leverage, delivered strong performance last year as investors bid up these companies significantly. Despite this performance, participants have failed to fully appreciate the ability to isolate and harness quality within portfolios, and the category attracted only $740 million in net flows for the year (compared with $18 billion for value ETFs). In 2018, watch for quality ETFs to start taking in assets, with recent performance grabbing attention, especially as investors begin to understand how high-quality strategies can complement existing portfolio investments.
In Fixed Income, Watch High Yield and Emerging Markets
As the ETF market has evolved with a greater depth of participants, and as regulatory changes have impacted the bond market structure, a greater number of investors, both large and small, have developed more faith in fixed income ETF liquidity. This is confirmed by fixed income ETF flows in 2017, when taxable bond ETFs topped $100 billion in annual net flows for the first time. This is not a blip on the radar, and we believe a variety of fixed income ETFs will continue to see record inflows in 2018. However, high- yield ETF flows may be volatile. While default levels are expected to remain low as borrowers continue to show solid net interest coverage, credit spreads remain tight with relatively little room for price appreciation. These competing factors will likely contribute to uncertainty in high-yield ETF flows. With this in mind, we suggest investors look at junk bond flows as an indicator of potential overall risk appetite. Exhibit 6 looks at four weeks in 2017 when high-yield fixed income ETF outflows forewarned a subsequent week of underperformance for the S&P 500 Index. High-yield ETF category flows shot higher in the following week as performance recovered. We believe high-yield ETF flows may continue to be sentiment driven this year.
We believe that emerging market (EM) debt and commodities ETFs may also draw flows in 2018.
- EM debt ETF assets have begun to grow as the difference in high yield and EM local currency debt spreads has narrowed. With higher yields and the dollar weakening versus many EM currencies, locally denominated offers U.S. investors attractive real yields. Flows have followed, and we believe this dynamic will remain in place.
- Investor disappointment in commodities has been reflected in ETF flows, which have topped $10 billion in net positive flows only once in the last seven years. As the global recovery becomes more synchronized across emerging and developed countries, however, this headwind may turn around. The prospect of higher U.S. inflation—even if it doesn’t materialize—may also convince investors to reconsider commodities.
The United States has seen a nine-year bull market that most predict will continue in 2018. Even if market volatility picks up, watch for ETFs to continue benefitting from investor interest in 2018.
Our opinion is that tax reform can provide more cyclical sectors a head start in the first half of 2018, given the short-term earnings boost they receive under the new corporate tax rates. ETF investors that have been positioning toward these cyclical sectors and value stocks with this in mind will likely continue to do so. Meanwhile, with the recovery looking more globally oriented than it had previously, ETF investors may continue to show confidence in international equity and fixed income strategies. Indeed, the prospects for higher growth and, therefore, higher returns remain attractive outside the United States, as most countries favor more accommodative monetary policies and appear to be in an earlier stage of the global expansion. In other words, expect many 2017 ETF flows to be consistent with 2018.
Read our full 2017 ETF Flow Update and 2018 Outlook for more on which asset classes we expect to attract investors this year.
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