Fixed-income ETFs lose their lustre

These fears came to the forefront late last May following the announcement by the U.S. Federal Reserve Board that it would taper its monetary stimulus program aimed at supporting growth in the U.S. economy because of indications that the economy was growing faster than anticipated.

As a result, says Yves Rebetez, managing director and editor of the website ETF Insight (www.etfinsight.ca), in Toronto: “For the first time in quite some time, fixed-income ETFs ended up in the red. It is an environment in which people vote with their feet with regard to the fear of potentially higher interest rates.”

However, the reality is that yields have inched upward following the initial talks of tapering. “If you look at the yield curve since the Fed started talking about tapering,” says Alfred Lee, vice president, BMO ETFs, and portfolio manager and investment strategist with BMO Asset Management Inc. in Toronto, “30-year bond yields have gone up by 95 basis points. Yields may not rise much more, but there is little downside left.”

In the aftermath of the Fed announcement, inflows into fixed-income ETFs fell to $76 million in June from $630 million in May. Fixed-income ETFs have been in the red since, with outflows of $860 million between July and October, according to statistics published by the Toronto-based Canadian ETF Association. For the year-to-date period ended Oct. 31, the category’s share of total ETF AUM has fallen to 30.7% from 32.7%.

The magnitude of fixed-income ETF outflows, which reached a recent high of $452 million in September, slowed markedly in October, however, following the Fed’s announcement in September that it will postpone its tapering plans, says Rebetez, “resulting in a bit of recovery in bonds.”

Although outflows from investment-grade bond ETFs have been the largest, Rebetez notes, “not all bond ETFs are created equal.” As a result, he adds, “there has been a bit of migration from longer-duration bonds to shorter-duration and floating-rate bonds in anticipation of higher interest rates.”

Says Lee: “People have either been hugging the short end of the curve to minimize duration risk or sitting in cash.” But, he cautions, clients still need fixed-income in their portfolios and tactical asset allocation in fixed-income is going to become more important. He foresees money flowing into broad-based bond ETFs in the future.

Although fixed-income ETFs have lost favour, investors have rotated into equities-based ETFs, which saw positive inflows of $2.2 billion between May and October, increasing the share of equities-based ETFs as a percentage of total ETF AUM to 64.3% at the end of October from 62.2% at the beginning of the year.

However, inflows were erratic, in terms of both category and dollar amounts, following the Fed’s tapering announcement last spring.

In June, for instance, Canadian equities-based ETFs saw inflows of $1.1 billion, followed by outflows of $1.3 billion in the next two months, then inflows of $523 million in September and outflows of $149 million in October. Canadian equities still represent the largest component of ETF AUM, at 38.6% of total AUM as of Oct. 31 – which is down from 40% at the beginning of the year.

The total outflows from Canadian equities-based ETFs have been distorted by large redemptions from certain funds, Rebetez says, while the majority of funds have had positive inflows.

On the other hand, ETFs based on U.S. and global equities experienced consistently positive inflows over the May-October period, totalling $1.3 billion and $407 million, respectively.

Rebetez says the rotation into equities can be attributed to surprisingly resilient markets in spite of volatility. He suggests that all equities markets have performed relatively well this year: “The U.S., in particular, has been very solid.”

Investors “are realizing that they have been too cautious and stayed on the sidelines for too long,” Rebetez says, and are becoming increasingly confident in the economic recovery. This could both provide upside for equities investments and counter potential losses resulting from higher interest rates.

Lee suggests that as economic conditions continue to improve, “momentum-oriented investors are beginning to chase performance” – thus fuelling the shift to equities-based ETFs.

Commodities-based ETFs also experienced positive inflows between August and October amounting to $229 million, compared with outflows of $77 million over the previous three months.

The shift into commodities-based ETFs, suggests Lee, is due to the fact that “more cyclical-oriented areas are starting to outperform in a strengthening economy.”

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