July ETF Flows: Is 2020 an Infinite Loop?

In an infinite loop, events are continuously repeated. One example is a bug in a video game that prevents a character from escaping a situation. The most famous examples come from movies, like “Groundhog Day” or the more recent “Palm Springs.” In the movie version of an infinite loop, the protagonist’s day continuously repeats. The chess board stays the same and the pieces can be moved in any direction the “looper” pleases.

2020 feels like its own infinite loop, resulting from the societal and economic impacts of COVID-19. Our chess board has stayed the same since the pandemic’s onset:

• Ongoing quarantine and social distancing measures as a result of the rise in case rates, with hot spots flashing in major US areas.
• Repeated concerns about economic and fundamental growth trends as consumer and corporate behaviors have been upended and millions of people are out of work.
• Recurring gains from Technology and other growth exposures; mega-cap growth stocks have advanced 16% in 2020 year-to-date and 55% since the market bottom¹ to land back at all-time highs, undeterred by antitrust headlines.

Parts of the economy have been reopened and some sports are back—the chess pieces have been rearranged—but largely, our situation has remained the same during the last few months, characterized by uncertainty, high market volatility, and Zoom-heavy daily habits. 

ETF flows: Fixed income breaks records, gold on a hot streak
Monthly fixed income flows surpassed $20 billion for the fourth month in a row—a record streak for the asset class and a mark that equities haven’t been able to achieve in any period during the last five years. Equity ETF flows were barely positive this month and fall well short of bond ETF flows over the year-to-date period. In fact, the $112 billion amassed by fixed income ETFs over the last four months has pushed the category’s year-to-date total to $124 billion, which is $33 billion above last year’s record-setting pace. With two more months of $20 billion-plus flows, the 2019 full-year record would be broken in only nine months. These flows are explained by two variables:

1. Specific investor needs to generate income in a low rate environment and target market segments receiving implicit and explicit Federal Reserve support.
2. More demand from investors who recognize the flexibility of bond ETFs. The vehicles enable investors to tailor portfolios in a liquid, transparent, and cost-efficient manner—all in real-time. Use cases such as cash equitization, active manager replacement, tactical allocation tools within ETF models, and liquidity management are some of the reasons why demand has recently increased following a period during which the structure was significantly tested.

Together, four straight months of massive inflows and positive market movement—core bonds, IG credit, and high yield returns are all positive year-to-date—have pushed assets under management for US-listed fixed income ETFs to more than $1 trillion for the first time ever, as shown below. Assets are just shy of the full-year 2020 projection we published in fall 2019.

Fixed income is not the only asset class on a hot streak: Gold ETFs have taken in more than $1 billion for a record seven consecutive months, pushing the year-to-date inflow total to a record high. With gold prices flirting with $2,000/oz and supportive macro factors (including low real rates, heightened macro risk, and a weakening US dollar), investors have gravitated towards this market segment in search of a source of potential return and a possible way to mitigate risk in a significantly uncertain market.

Compared to the 2009—the prior annual record for gold ETF flows—flows in 2020 are on another level. US-listed gold ETFs have taken in more than $30 billion this year, as shown below, and are now $18 billion above the 2009 totals. Granted, the 2020 flows do reflect the higher spot price today compared to 2009; however, when viewing this in gold tonnage terms, gold ETFs in 2020 are still outpacing 2009.

Fixed income ETF flows: Investors focus on credit-oriented funds
Taking a closer look at the strong fixed income ETF flows, we see that the combined $60 billion channeled into credit-oriented ETFs has been a key catalyst. These flows noticeably spiked following the announcement by the Federal Reserve (Fed) of its intentions to buy single-CUSIP corporate debt as well as credit-focused ETFs. This quelled some market concerns of apocalyptic default scenarios and spurred risk taking. As a result, credit spreads tightened and investors chose not to fight the Fed—a strategy we discussed as a potential option in our mid-year Outlook.

Within credit-oriented ETFs, the high yield segment outpaced investment grade in July after lagging behind in June, as shown below. The $20 billion year-to-date inflow into high yield would be a full-year record if 2020 ended today. Additionally, high yield is the leading bond segment in terms of asset growth (34.38%) this year.

Equity ETF flows: Dispersion across sectors
In July, sector-focused equity ETFs posted inflows in aggregate, a bright spot for equity ETFs overall, which have seen lackluster flows amid market volatility. As shown below, Health Care and Technology continued to have inflows, pushing their year-to-date totals higher, while Energy—a sector that has been fraught with volatility and was the lone negative performer in July—took in almost $1 billion last month and now is only second to Technology in terms of flows over the last twelve months. Four sectors, however, had outflows, with Real Estate the hardest hit—likely a reflection of the rise in work-from-home capabilities that may leave office real estate less attractive.

The dispersion across sector flows is reflective of the highly disperse return environment, as trailing three-month sector return dispersion remains above long-term averages. With a wide difference between winners and losers, investors have continued to position tactically based on specific market views, using sector exposures as a key tool.

Investors have a continued preference for Health Care and Technology stocks. The interest in Health Care is logical, as a health solution may be the catalyst to break out of our infinite loop and such firms have continued to show strong earnings sentiment. Tech flows reflect investors’ desire to participate in the sea change in societal behavior, where technology is going to play a larger role in keeping us digitally connected in a physically separate world.

Smart beta ETFs face steep outflows
Smart beta strategies have experienced a deluge of outflows over the past five months, totaling more than $18 billion after another $2 billion left in July. This five-month stretch of outflows is the longest on record for factor-driven strategies, and now, every factor category we track has landed in net outflow territory for the year-to-date period, with the exception of Quality.

As shown below, the outflows have been driven by two major segments: Dividend and Low Volatility. Investors need income, but income generation has come at a price given that 97% of broad market or large-cap US-focused dividend funds are underperforming the S&P 500® Index² as a result of dividend strategies’ inherent value bias—and value has done terribly this year around the world.

With markets in rally mode—juxtaposed against a backdrop of a pandemic, social unrest, geopolitical tensions, and recessionary growth—low volatility exposures have trailed and investors have found little use for them.

Quality is the only real outlier over all time periods measured. This is not a surprise, given it is the second-best performing factor over the trailing three-month and year-to-date periods, as the market has rewarded firms with more stable balance sheets and strong earnings potential in a growth-challenged environment.

Breaking free from 2020’s infinite loop
Breaking free from 2020’s infinite loop is a function of three actions: a vaccine, adherence to health guidelines, and cohesive government actions that provide the stimulus and support needed to restart the engines of growth. Until then, expect more of the same: Volatility and uncertainty are the standard and yields above 2% are only obtainable by taking on credit risk. Technology/growth stocks are likely to still power returns, as the products and services offered by these firms are sought after in our new digital world.