July ETF Monthly: Conclusions from a deep dive

From

The inaugural Risk Return Metrics (RRM) ETF Monthly publication provides detailed profiles of 180 ETFs.

The inaugural Risk Return Metrics (RRM) ETF Monthly publication provides detailed profiles of 180 ETFs, with both quantitative and qualitative content. ‘How to Use this Publication’ guidance is provided within, given the differentiated nature of the report.

Based on the report, we focus on two key areas:

  1. performance over the last twelve months
  2. product trends with respect to fund flows.

Performance

When to go active (over passive)

Based on performance, backed by what makes intuitive sense, RRM has developed some firm views on when an ETF investor may wish to give serious consideration to an Active over Passive ETF. Limiting views to those sectors where there is a degree of choice of active strategies, we see superior performance in the following sectors:

  1. Emerging market equities, with Fidelity Global Emerging Markets ETF and the BetaShares Legg Mason Emerging Markets ETF being clear standout performers, including lower maximum drawdown metrics. A successful emerging markets strategy requires high selectivity with respect to both country/regional as well as company exposure.
  2. Bond strategies, with HBRD, ECOR, XARO and Van Eck’s actively managed EBND all being very solid performers from a risk-adjusted returns perspective. While XARO’s raw numbers may not look that strong, consider that it is a AAA/AA government bond strategy, and the passive investment grade bond comparables have recorded materially worse performance. In RRM’s view, a true through cycle debt strategy needs to be based on an active approach given the various ‘levers’ that need to be pulled to achieve such an outcome. This is borne out in relative performance.

Sector performance – equities and bonds

You could virtually draw an even line across the performance of broad based Australian and International equities ETFs. What has worked in the favour of Australian equities ETFs is the strong recovery in banks, ongoing resource sector strength, the rotation from Growth to Value and the strong rally in cyclicals (read a favourable performance of the mid to small-cap factor).

In contrast, many broad based international equities have been adversely impacted by the Growth to Value rotation (bear in mind that most such ETFs are highly US-centric, with typically 70% of the portfolio being exposed to the US and therefore with strong implicit Growth, mega cap (size), and technology sector factor biases). Additionally, for unhedged ETFs, the rally in the AUD/USD post March 2020 served as a headwind to performance, generally in the order of 10% over 12-months.

In bonds, investment grade typically government and semi-government strategies got hammered in February 2021 on account of raising concerns about reflation and the prospect of QE tapering from central banks. Almost all of the investment grade bond ETFs are very long duration and fixed rate bond strategies, and therefore have high inflation / rising interest rate risk.

In contrast, the high yield strategies have performed materially better. Given high yield bonds are also fixed rate (and higher credit risk) this material outperformance may seem counter-intuitive. However, it is exactly this higher credit risk (and materially shorter duration) in high yield bonds that historically has led to its performance being positively correlated to a pivot to reflation / rising interest rates. Such an environment has as a corollary an improving economic growth outlook and it is corporate issuers of high yield bonds that benefit most from a credit risk de-rating (thereby reducing spreads and increasing bond prices).

Fund flows and product trends

From a fund flows perspective, and focusing on the last quarter, it is a continuation of more recent trends, namely the vast majority of money is flowing into international equities ETFs over Australian equities ETFs. Approximately $4.4bn flowed into the Australian ETF sector as a whole over 2QCY21, making it the seventh largest on record. Of that, 61% flowed into international equities ETF and only 13% into Australian equities ETFs.

Of the $4.4bn, approximately 22% went into ‘smart beta’ equities strategies. RRM classifies smart beta as anything that is not tracking a market cap index, ranging from something as simple as equal weight, to factor ETFs ranging up to Wide MOAT strategies. Of the total ETF market, smart beta equities strategies account for approximately $16bn of total ETF market FUM, or the equivalent of 14% of the total market. In short, the market is witnessing an ever increasing flow into smart beta (and active) relative to passive equities strategies, that latter of which accounts for approximately 58% of total market FUM.

From a portfolio allocation perspective, this smart beta growth makes a lot of sense when you consider that 1) a majority of investment strategies are either explicitly or implicitly based on market cap weighted indices that have a) material concentration exposures, b) large to mega-cap size factor biases and, c) over much of the last decade, a Growth factor bias.

Thematic ETFs are also exhibiting strong relative growth, and provide a strong tactical tilt along being a suitable ‘satellite’ component of a ‘Core-Satellite’ portfolio construction approach (with the market cap weighted broad market ETFs providing a suitable Core component).

Interestingly the investment grade bond ETF category has remained relatively stable despite recent poor performance and the persistence of negative real yields. Again, from a portfolio perspective there is merit to remaining invested in the sector. There are plenty of “fully invested Bears out there”. That is, those that believe the market is toppy and ripe for a correction but do not want to miss out on a continued run in equities market. While such strategies may not be providing much in the way of positive returns, they do provide downside protection.

Read the full report.

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