Despite the volatility, US-listed fund flows remained positive for the month. But there were pockets of dislocation where the pace of flows quickened or reversed course as investors re-priced risk assets and reassessed the current volatility landscape.
Russia’s invasion of Ukraine has caused a meaningful repricing of risk assets and ushered in a new era of geopolitical conflict. While telegraphed ahead of time by US intelligence agencies1 as a possible maneuver by the Russian government, a full-scale invasion across many fronts was the worst-case scenario and took the markets and public a bit by surprise.
There are many paths this conflict can take, with each path leading to a wide variety of intended and unintended consequences like an overgrown binomial tree. Trying to model any market move based on what occurred during the annexation of Crimea in 2014 is unlikely to be valuable, given how different the circumstances and responses are this time.
Rather than game theory the path dependence of each potential outcome, focusing on these “known knowns” may be more helpful in dissecting the current dislocation of market sentiment:
elevated volatility for a while
a 50-basis point hike at the Federal Reserve March meeting is off the table
direct spillover risk to US earnings is low given the low amount of sales from Russia
inflationary pressures will continue to persist given the interconnectedness of the Russia-Ukraine region to the commodity markets
The other known known is how investors have reacted and positioned portfolios in the last few days of the month as the conflict unfolded.
Flows Persisted As Volatility Increased
Despite the volatility, flows remained positive for the month. In fact, overall US-listed ETF flows were the eighth-most ever in February, totaling $78 billion. And since the start of the invasion, ETFs have had $15 billion of inflows, led by over $8 billion into equities.
The post-invasion flows trended at a higher rate than the pace of inflows from earlier in the month. In the 17 days leading up to the invasion, ETFs took in, on average, $3.7 billion a day compared to $5 billion in the final three days of the month.
The strong flows speak to the fungibility and flexibility of the ETF structure (i.e., ability to go short, use derivatives, and source liquidity) in addition to the ongoing secular demand that has buoyed assets over the years.
On a notional basis, equities led flows post-invasion. Yet fixed income had the greatest inflows as a percentage of total flows for the month. As shown below, the $5 billion amassed by bond funds in the last few days of the month equated to 55% of the overall February figure. In fact, of the three major asset classes, equity funds took in the least amount on a relative basis compared to the flows witnessed leading up to the invasion.
February Flow Comparison by Asset Class
Commodities had more interesting flows, however. With commodity prices rising, commodity-focused ETFs had $4.5 billion of inflows, or 3.2% of their start-of-month assets — the most of the three major ETF asset classes. And while all five sub-categories (Precious Metals, Industrial Metals, Energy, Broad-based, and Agriculture) had inflows, broad-based funds led the overall category. Broad-based funds amassed $2.5 billion, their second-most ever for a month, after nearly $1 billion was added in the last three days of February.
Sectors in Outflows, but Saw Inflows Post-conflict
Sector funds, in aggregate, posted outflows (-$646 million) for the first time in 16 months, ending a record streak that began at the onset of the pandemic rally. The weakness was equally distributed, with six of the 11 sectors posting outflows on the month. And the outflows were felt in both defensive and cyclical market segments, so no specific trend can be gleaned through that lens.
Flows, however, were positive over the last three trading days (+$729 million). This time, eight of the 11 sectors had inflows — led by $615 million into Energy-focused ETFs. And on the month, that sector was the only segment to receive any significant allocation (+$1.1 billion). Given its interconnectedness to the conflict, the Energy sector is likely to continue witnessing elevated interest.
The allocation to Energy was the inverse of the activity and sentiment expressed toward Financials. The sector had $470 million of outflows on the month, with $1.1 billion coming in the final three trading days.
Sector Fund Flows
Risk-off Within Bonds
Government bond funds comprised 67% of the total fund flows into bond ETFs during the month and 32% during the final three trading days since the start of the invasion.
The flows were primarily driven by short-term government exposures, an area of the Treasury curve that has low correlations to equities2 and is likely to witness an increase in yield given the high likelihood of the Fed raising rates in March.
Treasury Inflation-Protected Securities (TIPS) gained 2.2% over the final days of the month, outperforming nominal Treasuries by 1.5% in February overall. Given the expectations of higher inflation, TIPS ETFs witnessed inflows to close the month out (+$423 million).
Fixed Income Sector Flows
The Known Unknowns Are More Important
Knowing the known knowns helps to remove some of the noise and provides context as to why markets may be moving in one direction or the other. Yet, right now, it is going to be the outcome of the known unknowns that determines the direction of the market and risk aversion — in addition to, and more importantly, the impact on a humanitarian level for the people of Ukraine.
In times of crisis there is an ever-present urge to do something. Anything at all. Anything that can help alleviate the stress of the situation. And you can do that by offering emotional support to anyone connected to the conflict or sending donations to humanitarian and relief efforts.
From an investment perspective, however, the opposite action is likely the more optimal course given how dislocated markets are and how we have witnessed both vibrant drawdowns and rallies. Rather than having a “don’t just sit there, do something” mindset, investors should perhaps adhere to a “let’s sit here and do nothing” point of view in volatile times like this, allowing for diversification tools to do the intended work within portfolios.
1 “U.S. Spies Made Right Call on Russia Invasion, Buying Biden Time”, Bloomberg, February 24, 2022. 2 Bloomberg Finance L.P., as of 1/31/2022. BIL 3-Year correlation versus S&P 500 Index = -0.28, versus MSCI ACWI Index = -0.29, versus Barclays US Agg Index = 0.36.
CBOE VIX Index
A measure of implied market volatility on the S&P 500
Difference between returns across assets
Characterized by higher price levels relative to fundamentals, such as earnings.
ICE BofA US High Yield Index
The ICE BofA US High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.
A measure of bond market implied volatility
MSCI World Index
A market-capitalization-weighted stock market index that measures the stock performance of the companies in developed markets.
MSCI Emerging Markets Index
A market-capitalization-weighted stock market index that measures the stock performance of the companies in emerging markets.
S&P 500® Index
A market-capitalization-weighted stock market index that measures the stock performance of the 500 largest publicly traded companies in the United States.
S&P/LSTA Leverage Loan Index
A market value-weighted index designed to measure the performance of the US leveraged loan market based upon market weightings, spreads and interest payments.
A term for rules-based investment strategies that don’t use conventional market-cap weightings.
Characterized by lower price levels relative to fundamentals, such as earnings.
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