ETF Inflows Favor Fixed Income over Equity

by Wayne Ferbert on May 7th, 2012

Fund flows in to ETFs have followed an interesting trend so far in 2012. In fact, the trend has been different than I expected. The stock market has had a very good rally in Q1 2012 – up 10%+. This followed the last quarter of 2011 that was also +10%. Usually, such a rally would drive investors to the market for equities. No one wants to miss the boat, after all.

But instead, the largest inflows within the largest 50 ETFs came in the fixed income category – and not the equity category. According to Morningstar, the YTD estimated inflows for the top 50 largest ETFs by AUM saw a net inflow of 11.4% to fixed income exchange traded funds (ETF) versus a net inflow of 2.5% to the equity ETFs.

The top 50 ETFs have over $780 billion in total AUM. Interestingly, even though AUM in the equity ETFs among the top 50 total more than 4x the total of the fixed income ETFs in the top 50, the total new flows were almost equal: $15.3 B vs. $14.0B.  That is a fairly impressive trend in only 4 short months – given the disparity in the size of the AUM in each category.

With the surge in the equity markets, I guess I expected to see a lot of investors chasing the surge – but it really doesn’t show up in the data. So, when we look a little closer at the fixed income inflows, we see some interesting data: the largest winner in the fixed income space was by far the High Yield Fixed Income category with a 23% net flow increase.

The next closest category was the intermediate bond category at 15% and the long-term category at 13%. In the end, investors are moving material amounts of funds in to high yield bonds – the most risky bond category from a credit risk perspective. When does this kind of trend typically happen? It happens when the view on interest rate risk is skewed enough to make it happen.

If one believes that interest rates are set to rise – and potentially rise sharply – then the move to high yield is more defensive in nature. The higher yield will not be set to move by as much on a percentage basis as the lower yield, high quality bonds. So, the high yield fund prices will not need to move as much in price to reflect newer and higher yields.

Lipper reported last week that Junk Bond ETFs and Mutual Funds had net inflows in the week ending May 2nd of $1.19 Billion. Further, Lipper reports that these funds have seen net inflows in 21 of the past 22 weeks.

I think this move is really defensive in nature. The markets are saying: (1) I am not convinced the market rally in equities is long-lasting; and (2) that if I am to invest in fixed income instead of equities, then the higher yield fixed income is more defensive given interest rate risks.

This is not a very common circumstance for the market to find itself in: high yield fixed income is seen as defensive in nature; particularly, when the move is caused by the lowest interest rate environment in our lifetime. But these are not ordinary economic times either.

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