SMSFundamentals: Record Growth In ETF Markets

SMSFundamentals | Oct 14 2021

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Record Growth In ETF Markets

The month of September was the weakest for equities this year, but that did not stop investors piling into ETFs both domestic and international, equity and fixed income.

-September quarter strongest on record for ETFs globally
-International ETFs attracted attention
-Corporate bonds offered diversification

By Greg Peel

London-based EFTGI is an independent research and consulting firm covering trends in the global exchange-traded funds (ETF) and exchange-traded products (ETP) markets.

(The difference is largely semantical – “funds” typically imply financial instruments and “products” imply commodities, for example. We’ll just call them all “ETFs” for the purpose.)

EFTGI reports global ETFs saw inflows of US$90bn in the month of September, bringing year to date net inflows to a record US$924bn. This well exceeds equivalent year to date inflows last year of US$487bn, and full-year 2020 flows of US$763bn.

Mind you, 2020 was a rather unusual year.

For those unfamiliar, ETFs blend the characteristics of listed investment companies (LIC) and futures contracts.

LICs are companies listed on the ASX which invest in companies listed on the ASX. Like any listed companies, they must raise equity via an IPO and trade in the secondary market in which if you want to sell, there has to be a buyer on the other side.

Futures contracts do not “IPO”, they are simply created when a buyer meets a seller (who could be selling short) and are dissolved if long and short positions net out. The drawback for longer term investors is that futures contracts expire, so you have to start again.

ETFs are similar in that they do not exist unless a buyer meets a seller, but unlike futures the sponsor of that ETF ensures they are themselves always there as a buyer or seller if no one else is, on a reasonable spread. And ETFs do not expire.

ETFs are many and varied, from tracking the ASX200, to tracking a particular sector of the index, to tracking a target investment goal (such as high-yield), as well as offering investments in government or corporate bonds, cash, commodities, international markets and just about anything you can think of.

ETFs can be either “passive” or “active”. An index ETF is “passive”, as the sponsor offers the buyer an investment in the index but is agnostic as to whether it goes up or down. Here the investor has made the choice.

In an “active ETF”, the sponsor’s goal is to outperform a particular benchmark, such as the ASX200, through stock-picking and occasional portfolio rotation. Here the sponsor is making the choice, and the investor hopes it’s the right one.

The benefit of ETFs is that they take the hard work away from the investor, and in their number provide for one’s own portfolio diversification. And they are listed on the exchange, just like stocks.

The two biggest sponsors of Australian listed ETFs are US-based Vanguard and BetaShares (amid some thirty-odd). Each month they both like to highlight the performances of their own ETFs in terms of both inflows and returns, but for the investor, selecting an ETF is more about the product itself rather than who sponsors it. The bananas aren’t necessarily better at Coles than at Woolworths.

Buy the Dip

September was 2021’s weakest month for equities both Australian and global, yet locally-listed ETFs (which can be either domestic or international) saw the highest monthly inflows on record at $2.9bn, BetaShares reports.

BetaShares also saw its own record inflows, at an industry-high of $1.14bn, beating the previous record held by Vanguard ($1.05bn), BetaShares is thrilled to point out.

In a month in which equity markets fall, total asset value of ETFs would decline, unless new flows into ETFs provide the counter. This was the case in September, as while share prices fell, total ETF value grew slightly to a new high of $125.3bn.

The balance of flows this month was decidedly more mixed than the pattern observed in the year so far, notes BetaShares, with Australian and International equities receiving approximately the same amount of flow ($950m and $963m respectively). There was also a return to meaningful flows into Cash ($382m) and Fixed Income ($333m).

The compositions of the industry’s flows, suggest BetaShares, illustrates the extent to which ETFs are able to help investors diversify their portfolios across all major asset classes.

There are currently 268 ETFs listed on the ASX. The most recent listing taps into the ESG theme, with Janus Henderson launching its Global Equities Sustainable Active fund.

Vanguard may have been pipped at the post by BetaShares but focusing on the September quarter, rather than month, Vanguard also boasted record inflows of $2.9bn, which is $757m more than the previous best.

Market-wide, the September quarter was the strongest on record, with $9bn in flows.

“It’s encouraging to see such uptake of ETFs,” says Minh Tieu, Vanguard’s Head of ETF Capital Markets, Asia-Pacific. “The inherent diversification benefits of ETFs coupled with their low-cost, easily-accessible nature makes them an increasingly popular investment option for both new and seasoned investors alike”.

Vanguard estimates the Australian ETF industry will reach the next $100bn of assets under management in half the time it took to reach the first $100bn.

Think Globally

Global equity ETFs continued to be the product of choice for Australia investors in the September quarter, marking 50% year on year growth.

“Whether it’s because they’re optimistic about the global economic recovery or simply wanting to diversify away from home markets, more funds are flowing into international equity ETFs this year than into Australian equity ETFs,” notes Minh.

There was also a shift from currency-hedged international ETFs among Vanguard’s offerings towards unhedged ETFs.

“The changing preference from hedged ETFs to unhedged ETFs is a possible indication that investors are anticipating a drop in the Australian dollar,” suggests Minh. “If that’s the case, there may be some currency downsides for hedged investors should the Australian dollar depreciate.”

Vanguard does not however recommend speculation on currency via ETFs. Currency movements may be volatile over the short term but Vanguard research shows currency movements have a neutral impact over the longer term.

The decision to hedge or not to hedge should be most informed by an investor’s individual time frame and risk tolerance.

Diversify

A longer term investor requires a balance of risk and reward, which can be achieved by diversification among stocks and sectors but furthermore diversification among asset classes. The default fund for hands-off super investors is the so-called “balanced fund”, which typically invests 60/35/5% in stocks, bonds and cash.

The diversity of ETFs offers portfolio diversity for hands-on investors, but there are also ETFs which are themselves diversified. Diversified or multi-asset ETFs grew to a value of $564m in the September quarter, up from $400m in the June quarter.

One would be forgiven in the current market for steering away from fixed income, given negative real rates on offer, but corporate bonds offer better returns (with added risk) than government bonds and remain a means of portfolio diversification.

Flows into Australian corporate bond ETFs reached $75m in the September quarter, while government bond ETFs saw -$5m in outflows.

In a “normal” world, if there is such a thing, bond prices tend to rise if equity prices fall, and vice versa, as falling stock markets encourage a flight to safety. But currently the world is far from normal, and the month of September in particular saw weakness in both stocks and government bond prices (higher yields).

So in the short term, it doesn’t always work. But…

“Bonds will always be a worthy investment choice because of their ability to protect investors against downside risk,” says Minh. “While nobody can accurately time the market, we know its cyclical nature means a slow-down in equity growth may one day come. This means investors who are not adequately diversified at that point in time may experience, sometimes significant, adverse movements in their portfolio value. Bonds however will cushion that fall, or at least reduce portfolio volatility.

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