April ETF Flows: Murky Fundamentals Fuel Caution

Did you know that water 30,000 feet beneath the surface is just as transparent as water just one inch below? It’s just that at greater depths, less light and more particles make the water appear murky.

It struck me that today’s narrow market leadership, negative US earnings growth and stretched valuations, recessionary fears, and evolving monetary policy are like particles clouding investors’ vision as we get deeper into 2023.

As a result of murky fundamentals, buying behavior has been restrained, despite the broad market gains to start the year.

Weak Equity and Robust Bond Inflows Show Cautious Positioning

In April, total ETF flows were just $29 billion. This is 34% below the historical 5-year average and the 5-year April average of $32 billion.

The weakness stems from a lack of equity buying, as shown below. Equity fund inflows were 44% below their historical average. Meanwhile, fixed income flows were 1% above their typical rate.

So far this year, bond inflows (+$66 billion) have outpaced equity inflows (+$45 billion). Low equity inflows stem from limited interest in US equities in particular.

Lackluster equity inflows and robust bond inflows have pushed the rolling three-month differential to extremes. In fact, it’s in the lowest fifth percentile over the past 15 years, as shown below. This reflects investors’ preference for fixed income exposures amid their elevated yields and a murky macro outlook.

Year to Date, Investors Favor International ETFs

The $12.5 billion of inflows in April just turned year-to-date figures for US equity ETFs positive. But those April flows were still 40% below their historical 5-year average.

Non-US equity ETFs took in $5 billion in April. Higher inflows into US equities relative to non-US could indicate a change in buying behavior, as international exposures have posted 290% more inflows than US funds ($35 billion versus $12 billion) so far this year. But accounting for size of market, the $5 billion of non-US flows in April equates to a 0.5% start-of-month asset increase, compared to 0.3% for US funds.

Within international exposures, investors continue to prefer developed ex-US as well as European regional allocations. The latter saw $1 billion of inflows and now has over $10 billion on the year.

Meanwhile, developed ex-US ETFs took in $2.4 billion in April, pushing their year-to-date total to over $15 billion, a 3.2% increase to start-of-year assets. In fact, international developed ex-US funds have had inflows for 34 consecutive months —tying the prior record from 2015 to 2018.

Moving Up in Quality, Playing Defense in the US

Sector ETF outflows this year have weighed on US total flow figures. However, sectors bounced back in April, taking in $787 million — their first month with inflows since November 2022. While this appears to indicate renewed risk taking, defensive allocations drove April’s positive sector flows.

Defensives (led by Consumer Staples) took in $1.3 billion while cyclical sectors lost $600 million. Financials took in in $1.7 billion, as investors sought to position around supportive earnings from large banks amid ongoing industry turmoil.

The defensive preference and move up in quality within sectors was also evident within factor flows. Dividend equities took in $483 million, their 30th consecutive month with inflows. Quality funds added $2.4 billion, their second-most ever, and pushed year-to-date figures to over $11 billion — the most of any factor type.

Low Volatility ETFs also had inflows, taking in $663 million. Meanwhile, risk-on high beta stocks were not in favor as Momentum and Size factor funds posted outflows last month.

Caution and Courage in Bond ETF Flows

Broad-based Aggregate funds drove bond flows, taking in $5.6 billion. Meanwhile, government funds, led by long duration exposures, had over $1.6 billion of inflows as investors continued to position defensively. But bond investors did show a degree of courage on the month.

High yield ETFs took in $5.2 billion, their sixth-most ever for a month and a reversal of high yield’s outflows in three out of the four prior months. Year-to-date flows into high yield remain negative.

The $5 billion into high yield ETFs reversed the recent downward trend, as the rolling three-month flows for high yield ETFs broke through the bottom 10^th percentile in March. Now, the level has risen to the 13th percentile. Low, but improving.

Seeking Clarity Amid Murky Waters

With elevated valuations, negative earnings results, and revisions remaining skewed to the downside, US fundamentals offer limited clarity. Macro factors are also clouding the outlook.

Irrespective of prior recessionary periods or if the National Bureau of Economic Research (NBER) ever defines this cycle as a recession, economic activity indicators reflect stark sub-par growth. The US Leading Economic Indicator (LEI) year-over-year percentage change is negative. It has been negative and declining now for nine consecutive months.¹

We are also likely to witness one of the most contentious debt ceiling debates ever,² and the banking crisis continues to create headlines as well as calls for tighter regulation.

Lastly, Fed policy actions and conflicting expectations for what comes next have pushed realized volatility for the Bloomberg US Aggregate Bond Index into the 98th historical percentile.³

Unfortunately, investors don’t have sonar to navigate these murky waters. Because there is simply no way to know for certain what Fed policy will be or if US earnings have reached a bottom, position for whatever comes next. That means limiting portfolio risks in the hunt for yield with active core strategies and specific short-duration exposures. And it means moving up in quality in the US, while targeting more attractively priced international markets to limit any potential fundamental volatility.

For more insight into ETF flows along with the latest charts, scorecards, and investment ideas, visit Market Trends.