ETF investors jumped into a host of lossmaking trades in 2023

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Exchange traded fund investors pumped money into a host of lossmaking trades last year while pulling money out of a range of better-performing assets.

The unusual moves challenge the received wisdom that investors all too often jump on passing bandwagons and buy whatever is rising in value, typically at the wrong point in the cycle.

In the short term, at least, though, the divergences between performance and flows will have hit ETF investors in the pocket.

“Typically, ETF flows and returns are highly correlated. In 2023 the relationship broke down in many sectors and themes,” said Jared Woodard, investment and ETF strategist at Bank of America Securities.

The dichotomy was particularly stark in the bond market. Net flows into long-term US Treasury ETFs jumped, hitting $70bn, 69 per cent of the starting assets these funds held at the beginning of 2023, according to BofA data. Yet long-term Treasuries posted their third successive year of losses, shipping 4 per cent.

In contrast, high-yield bonds returned 11 per cent, senior loans 10 per cent and convertible bonds, an equity-fixed income hybrid, also 10 per cent. Yet flows to high-yield ETFs were flat, loan ETFs saw outflows of $1bn, or 6 per cent of assets under management, and convertibles ETFs saw a quarter of their assets, $1.5bn, walk out the door.

“In the Treasury market we saw pretty substantial losses for the third year in a row until the very end of the year,” Woodard said. “[Investors] were staring down big losses in their bond portfolio but they were quite happy to close their eyes and buy.

“Conversely, we saw parts of the market that had incredibly strong returns last year but nobody cared, or were even willing to sell.”

Woodard’s hypothesis was that at the start of 2023, there was a consensus that the US was heading for recession, and as a result the Federal Reserve would stop raising rates in short order, and maybe even start cutting them before the year was out, while rising defaults would lead to losses on higher-risk credit.

However, “none of that happened”, leaving people wrongfooted, but “some investors just weren’t interested in a midcourse correction and just thought ‘let’s ride this out for the year’.”

Todd Rosenbluth, head of research at VettaFi, a consultancy, said investors were “very conservative with their fixed-income exposures, certainly with taking on credit risk, in 2023, despite strong performance.

“There was a flight to quality, a flight to safety in Treasury ETFs,” with the iShares 20+ Year Treasury Bond ETF (TLT) alone sucking up $24.7bn, according to VettaFi data, despite the fund sporting losses until a rally in the final two months of the year.

Rosenbluth believed the flow pattern persisted “in part because you could get reasonably high yields in extremely safe investments”, and investors thought it was “better to get stability in their fixed income rather than reaching for yield”.

The gulf between returns and flows was also evident in several equity markets.

Latin American equities returned 24 per cent last year, but LatAm equity ETFs saw muted inflows of just $0.7bn, something Woodard attributed to potential “scepticism” as to the sustainability of the region’s outperformance, with political issues to the fore in the likes of Argentina and Chile.

In contrast, Chinese equities lost 12 per cent, but ETFs tracking them vacuumed up a net $68bn in the first 10 months of 2023, 28 per cent of their assets at the start of the year and the second-highest figure on record, just behind 2022’s full-year tally of $71bn.

The latter can perhaps be partially explained by politically driven purchases by China’s “national team” of state-affiliated institutions, rather than foreign investors.

BofA noted that over the past two years more than 90 per cent of flows to Chinese equity ETFs have come from non-US dollar denominated funds, “the overwhelming majority of which are listed in China”.

Elsewhere in Asia, Japanese equity ETFs that deploy currency hedging to strip the yen out of the equation returned a chunky 43 per cent last year, far ahead of the 15 per cent return of unhedged Japan ETFs, which were weighed down by the sliding yen. Yet it was the unhedged funds that pulled in the big money, $4.9bn, while the hedged variants attracted just $0.8bn.  

Rosenbluth believed US investors “have largely given up on using currency-hedged equity ETFs” since their heyday in 2014 and 2015 when the DXY dollar index rallied 23 per cent in two years, eroding returns for unhedged US investors.

But when the greenback fell back “the hedging hurt investors, they pulled money out and they largely haven’t come back. It’s a shame,” said Rosenbluth, who lauded the risk reduction currency hedging can provide.

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“If you don’t have a view on the dollar it makes sense to hedge to eliminate currency risk but most investors don’t seem to think there are benefits,” he added.

Woodard believed investors were often “willing to look past a wrinkle [such as currency-induced losses] for a year or so”, as switching from one ETF to a hedged version can crystallise a capital gains tax liability.

As for this year, Rosenbluth believed “[US] investors will be more willing to take on credit risk”, as concerns over recession fade and the Fed starts cutting rates, forcing those who target a given level of yield to move up the risk curve.

Woodard broadly concurred. “There is a massive consensus this year that all you need to buy is very high-rate bonds and you will make some nice returns.

“Maybe we will escape a wave of defaults this year and perhaps we will see another year where risky parts of the bond market beat Treasuries.”


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