What the heck is going on with exchange-traded funds? Inflows into ETFs this year are on pace to fall short of last year’s total, which in turn was smaller than the prior year’s total. It wasn’t long ago that ETF asset growth seemed poised to conquer the world. Now it seems the momentum has stalled.
But that doesn’t mean the ETF industry is in retreat. The key takeaway is that money is still flowing into the space, particularly into active ETFs, at the expense of mutual funds—a business that continues to bleed assets. The diminution of the mutual fund space could give rise to the next wave of ETF growth, now that more asset managers are figuring out which way the wind is blowing and beginning to package their actively managed mutual fund strategies in ETF wrappers.
As for the investment scene this year, a lot of investors hunkered down after getting burned in 2022 and played defense by sitting on cash in low-yielding accounts. But as interest rates kept rising and people realized they could earn 5% interest in cash, they went on offense by pouring their idle money—or transferring some of their existing investments—into money market funds that paid the higher rates. So in a year when cash is king, ETFs have been relegated to the status of minor royalty, relatively speaking.
“That’s one of the primary reasons why ETFs flows are lower this year,” says Aniket Ullal, head of ETF data and analytics at CFRA.
Let’s look at the numbers: As of this year’s third quarter there were 3,398 U.S.-listed ETFs with total assets of $7.2 trillion, according to Morningstar Direct. Those figures include exchange-traded notes, but these play such a small role that they don’t really influence the overall numbers, says Dan Sotiroff, a senior manager research analyst at Morningstar Research Services.
Net inflows into ETFs through this year’s third quarter were $326.6 billion, down nearly 19% from the inflows during the first three quarters of last year. Meanwhile, net outflows from open-end mutual funds were $283 billion as of the end of September (that’s an improvement from the nearly $597 billion in outflows during the same period last year).
Meanwhile, inflows into money market funds this year were $792 billion through the third quarter, according to the Investment Company Institute. During the same period last year they experienced outflows of nearly $198 billion.
As for where the excitement has been in ETFs this year, Ullal says that fixed income has accounted for about 40% of flows even though this asset class accounts for just 20% of ETFs in terms of both products and assets. “Within that, there has been a lot of interest in Treasury and sovereign bond ETFs,” he says. “You would expect in a rising-rate environment to see a lot more interest in shorter-duration bond ETFs, but we’ve actually seen interest across the entire duration spectrum.”
But going long on duration—especially on the far end—has been painful. Ullal points to the iShares 20+ Year Treasury Bond ETF (TLT), which took in $20 billion through the third quarter as investors tried to get ahead of the curve by positioning themselves for future interest rate cuts. But that fund was down 7.5% as of early November (even if that was an improvement from its 31% drop in 2022).
“I expect investors to be cautious on fixed income in early 2024, and wait to see what will happen because we’re still seeing strong employment, and inflation remains above the Fed’s target,” Ullal says.
Elsewhere, investors have gravitated toward currency-hedged ETFs, particularly in markets such as Japan. “Investors have been hurt by the appreciating dollar, but buying currency-hedged products that hedge that appreciation enables you to capture the local currency return,” Ullal says. “Currency hedging has been an effective strategy.”