The exchange-traded fund train slowed a bit this year, but it’s not in danger of being derailed … at least not yet.

Low-cost, large-cap index funds continue to thrive within ETF Land despite this year’s equity meltdown. Other ETF investments have also performed well in terms of gathering assets, including certain parts of the fixed-income market. And there’s been a surge in interest in buffered strategies that protect investors against downside losses in their investments.

“Despite one of the most challenging market environments in recent memory, ETFs are on track to finish 2022 with their second-best year of inflows ever. I find that highly impressive,” said Nathan Geraci, president of the ETF Store Inc., speaking via email. He said the inflows are surpassing 2020’s total of more than $500 billion, but behind last year’s total of more than $900 billion. His RIA builds portfolios composed mainly of exchange-traded funds.

He noted that financial advisors are leaning much more heavily on ETFs for overall portfolio construction, and ETF issuers are responding with new, innovative ways to slice and dice markets. “ETFs were already mainstream tools for advisors, but 2022 feels like a tipping point where ETFs are now unquestionably the investment vehicle of the future,” Geraci said.

Tom Roseen, head of research services at Refinitiv Lipper, suggests that many investors are sticking with passive large-cap U.S. equity funds as a relatively safe place to stay invested in a stock market that has been anything but safe.

“I think people are in a risk-off mode and they want to get back into the market,” he says. “That’s why we’re seeing that S&P 500 index funds are at the top in attracting money. Short-duration U.S. Treasurys are also at the top. Equity income funds are big gainers because investors are trying to duck for cover and they need current income. They’re buying deeply discounted equities that haven’t been cutting their yields.”

Other market watchers also see a trend toward more conservative allocations. “Within equities there’s been a big rotation into low-volatility and dividend strategies and away from high-growth, high-beta strategies such as fintech, robotics and automation, and the metaverse,” says Aniket Ullal, vice president of ETF data and analytics at CFRA.

He notes that investors are increasingly turning to buffered, or defined-outcome ETFs that typically employ an options-based strategy designed to provide preset upside and downside return potential benchmarked to a specific index. Innovator Capital Management introduced the first structured products within the ETF wrapper four years ago, and has since built a sizable product lineup of buffered products. Other ETF providers have launched their own buffered products, and Ullal sees this trend continuing.

“Investors are looking for ways to stay invested while managing risk, and we think these type of structured outcome ETFs could gain,” he says. “There have been a lot of launches of these funds and more flows going into these products.”

Then there are those funds within the broadly defined environmental, social and governance space, which have taken heat from critics for a variety of reasons. Among them are complaints about the amorphous nature of what exactly “ESG” constitutes, along with claims by certain money managers and politicians that the ETFs in this space are tools used by the left to enforce its agenda on the investing public at the expense of corporate profits.

Despite that, ESG funds remain popular with many investors. “ESG, or responsible investing, saw inflows on the ETF side,” says Roseen. “Responsible investing has a stickiness. People are willing to invest where their morals are.”

Shawn McNinch, managing director at Brown Brothers Harriman, says ESG products have had more traction in Europe but are getting traction in the U.S. as more institutional money goes into them. He also notes that advisors have been seeking out ESG funds, presumably to meet client demand.

McNinch sees a growing trend of asset managers converting their actively managed mutual funds into active ETFs. Notable examples are Dimensional Fund Advisors and JPMorgan.

“It’s sort of instant assets into the active ETF space,” says McNinch, whose firm provides a range of back office support services to ETF providers. “We supported three mutual fund-to-ETF conversions with active managers, and we have about five more in the pipeline.”

He adds that most of the conversions result in fully transparent products, as these managers are comfortable showing their daily holdings. “We’re not seeing as much traction with semi-transparent ETFs,” McNinch says, referring to products from asset managers mimicking their own existing active mutual funds but without the requirement of making daily portfolio disclosures.

Hammered Bonds
The Federal Reserve’s aggressive rate hikes have hammered bond prices and forced investors to seek refuge in short-duration bond funds. In his email, Geraci suggested it’s prudent for ETF investors to maintain a more conservative posture on fixed income and tilt toward shorter duration and higher quality holdings.

“There is no shortage of ETF options in this space,” he said, mentioning such products as the Pimco Enhanced Short Maturity Active ETF (MINT) and JPMorgan Ultra-Short Income ETF (JPST). “Investors might also give strong consideration to laddering target-date maturity bond ETFs given the flexibility this approach provides.”

One example he points to are exchange-traded funds in the Invesco BulletShares investment-grade corporate bond suite.

A Threat To ETF Dominance?
While some ETF watchers expect current trends to continue in the coming year, there’s a developing trend that might someday let some air out of the ETF balloon. And that’s the concept of direct indexing—a personalized investing strategy where people can buy specific securities within a particular index they want to replicate and customize the weightings or exclude certain stocks they don’t want to own. In effect, it turns vanilla beta exposure into a flexible tool allowing for more tax-loss harvesting opportunities, factor tilts and targeted ESG exposures, among other features.

According to a report this summer from Cerulli, direct indexing is expected to grow at an annualized rate of more than 12% over the next five years, faster than mutual funds, ETFs and separate accounts. But that 12% growth is coming off a small base.

Direct indexing has been a niche area traditionally reserved for high-net-worth clients, but the advent of commission-free trading and fractional shares could make it more doable for retail investors at large. It remains to be seen how that will affect ETFs down the road.

McNinch offers that it could be a threat if it can be done cheaply.

But CFRA’s Ullal thinks direct indexing and ETFs can co-exist just fine. “I think it’s more of a complement to ETFs because I think direct indexing caters to a different segment than the average ETF investor.”