ETF investors jumped into a host of lossmaking trades in 2023

Change traded fund traders pumped cash into a number of lossmaking trades final yr whereas pulling cash out of a spread of better-performing belongings.

The weird strikes problem the acquired knowledge that traders all too typically soar on passing bandwagons and purchase no matter is rising in worth, sometimes on the unsuitable level within the cycle.

Within the brief time period, not less than, although, the divergences between efficiency and flows could have hit ETF traders within the pocket.

“Usually, ETF flows and returns are extremely correlated. In 2023 the connection broke down in lots of sectors and themes,” stated Jared Woodard, funding and ETF strategist at Financial institution of America Securities.

The dichotomy was significantly stark within the bond market. Internet flows into long-term US Treasury ETFs jumped, hitting $70bn, 69 per cent of the beginning belongings these funds held firstly of 2023, in accordance with BofA information. But long-term Treasuries posted their third successive yr of losses, transport 4 per cent.

In distinction, high-yield bonds returned 11 per cent, senior loans 10 per cent and convertible bonds, an equity-fixed revenue hybrid, additionally 10 per cent. But flows to high-yield ETFs had been flat, mortgage ETFs noticed outflows of $1bn, or 6 per cent of belongings beneath administration, and convertibles ETFs noticed 1 / 4 of their belongings, $1.5bn, stroll out the door.

“Within the Treasury market we noticed fairly substantial losses for the third yr in a row till the very finish of the yr,” Woodard stated. “[Investors] had been staring down massive losses of their bond portfolio however they had been fairly joyful to shut their eyes and purchase.

“Conversely, we noticed elements of the market that had extremely robust returns final yr however no person cared, or had been even prepared to promote.”

Woodard’s speculation was that at first of 2023, there was a consensus that the US was heading for recession, and in consequence the Federal Reserve would cease elevating charges in brief order, and possibly even begin slicing them earlier than the yr was out, whereas rising defaults would result in losses on higher-risk credit score.

Nonetheless, “none of that occurred”, leaving individuals wrongfooted, however “some traders simply weren’t fascinated about a midcourse correction and simply thought ‘let’s journey this out for the yr’.”

Todd Rosenbluth, head of analysis at VettaFi, a consultancy, stated traders had been “very conservative with their fixed-income exposures, actually with taking over credit score threat, in 2023, regardless of robust efficiency.

“There was a flight to high quality, a flight to security in Treasury ETFs,” with the iShares 20+ Yr Treasury Bond ETF (TLT) alone sucking up $24.7bn, in accordance with VettaFi information, regardless of the fund sporting losses till a rally within the remaining two months of the yr.

Rosenbluth believed the stream sample endured “partially since you may get fairly excessive yields in extraordinarily secure investments”, and traders thought it was “higher to get stability of their mounted revenue fairly than reaching for yield”.

The gulf between returns and flows was additionally evident in a number of fairness markets.

Latin American equities returned 24 per cent final yr, however LatAm fairness ETFs noticed muted inflows of simply $0.7bn, one thing Woodard attributed to potential “scepticism” as to the sustainability of the area’s outperformance, with political points to the fore within the likes of Argentina and Chile.

In distinction, Chinese language equities misplaced 12 per cent, however ETFs monitoring them vacuumed up a internet $68bn within the first 10 months of 2023, 28 per cent of their belongings at first of the yr and the second-highest determine on file, simply behind 2022’s full-year tally of $71bn.

The latter can maybe be partially defined by politically pushed purchases by China’s “nationwide workforce” of state-affiliated establishments, fairly than international traders.

BofA famous that over the previous two years greater than 90 per cent of flows to Chinese language fairness ETFs have come from non-US greenback denominated funds, “the overwhelming majority of that are listed in China”.

Elsewhere in Asia, Japanese fairness ETFs that deploy forex hedging to strip the yen out of the equation returned a chunky 43 per cent final yr, far forward of the 15 per cent return of unhedged Japan ETFs, which had been weighed down by the sliding yen. But it was the unhedged funds that pulled within the massive cash, $4.9bn, whereas the hedged variants attracted simply $0.8bn.  

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

However when the buck fell again “the hedging harm traders, they pulled cash out they usually largely haven’t come again. It’s a disgrace,” stated Rosenbluth, who lauded the chance discount forex hedging can present.

“In case you don’t have a view on the greenback it is smart to hedge to eradicate forex threat however most traders don’t appear to assume there are advantages,” he added.

Woodard believed traders had been typically “prepared to look previous a wrinkle [such as currency-induced losses] for a yr or so”, as switching from one ETF to a hedged model can crystallise a capital features tax legal responsibility.

As for this yr, Rosenbluth believed “[US] traders will probably be extra prepared to tackle credit score threat”, as issues over recession fade and the Fed begins slicing charges, forcing those that goal a given stage of yield to maneuver up the chance curve.

Woodard broadly concurred. “There’s a large consensus this yr that every one you should purchase could be very high-rate bonds and you’ll make some good returns.

“Perhaps we’ll escape a wave of defaults this yr and maybe we’ll see one other yr the place dangerous elements of the bond market beat Treasuries.”