Rising interest rates and improved market outlook set to bring bond ETFs back in vogue in 2023

According to data recently released by the ASX and Vanguard, flows into bond ETFs in Q4 2022 gained momentum as investors sought to further diversify their portfolios amidst rising interest rates, a trend set to prevail in 2023.

Despite challenging conditions last year, ETFs still recorded $12.8 billion in cash flows. Vanguard accounted for 60 per cent of these flows and recorded its second-best year on record in terms of cash flows ($7.7 billion). Vanguard remains the largest ETF issuer in Australia and the Vanguard Australian Shares Index ETF (VAS) remains the most popular ETF.

Brighter days ahead for bonds

Flows into fixed income ETFs picked up significantly in late 2022, particularly into global bond ETFs (Q4: $492 million, Q3: $50 million).

Year on year however, domestic bond ETFs saw the highest increase in cash flows with 65 per cent, recording $2.8 billion in 2022 compared to $1.7 billion in 2021.

“In 2023, our return expectations for fixed income have significantly increased compared to a year ago. Thanks to higher starting interest rates as a result of central banks around the world working to quell persistent inflation, we forecast global bonds to return 3.9-4.9 per cent and domestic bonds to return 3.7-4.7 per cent over the next decade, a 2-percentage point increase,” said Minh Tieu, Vanguard’s Head of ETF Capital Markets, Asia-Pacific.

“We saw the beginning of increased demand for fixed income ETFs in late 2022 and expect investor interest to grow as this new year unfolds.

“The unusual correlation we saw between bonds and equities in 2022 is also set to end, delivering greater diversification benefits to balanced portfolio holders. On this note, last year we saw a lot of commentary about the death of the 60/40 portfolio and this year, likely to see a flip in sentiment declaring its resurgence as bond returns turn positive.

“While we’ve maintained that history has proven the worth of balanced portfolios no matter the market conditions, the key takeaway for investors here is that sticking with a diversified asset allocation and avoiding the urge to time the market is the best way to achieve long-term investment success, no matter which asset class is predicted to outperform”.

Global equities nearing fair value, outlook improving

International shares ETFs recorded $334 million in cash flows in Q4, down 59 per cent since Q3. Year on year, flows have dropped by 81 per cent (2022: $2.5 billion, 2021: $14.1 billion).

Flows into Australian shares ETFs remained steady, recording $816 million in Q4 (Q3: $805 million) and overall, experienced a smaller fall year on year than global equities (2022: $4.4 billion, 2021: $5.7 billion).

“Equity markets in 2022 were plagued by economic and geopolitical events significant enough to unsettle even the most seasoned investor, and this was reflected unsurprisingly in last year’s global equity ETF flows,” said Mr Tieu.

“Looking ahead, Vanguard’s outlook for global equities, including emerging markets, is improving as they near fair value. This is encouraging news for investors as lower valuations are generally more conducive to higher long-term returns.

“China’s reopening is also likely to buoy emerging market economies in Asia, although we forecast a notable divergence in emerging market growth as economies in Europe continue to battle inflation pressures and energy supply issues.

“ETF investors wondering where they should invest next should first and foremost consider their long-term goals, timeframe, and risk tolerance. Market outlooks are useful to consider but they shouldn’t dramatically alter asset allocations; what they should do is help set realistic expectations and encourage healthy portfolio diversification”.

History has proven ETFs to be resilient even in the face of recession

According to Vanguard’s 2023 economic and market outlook, there’s a 40 per cent chance of recession in Australia, notably lower than the 90 per cent odds placed on the U.S., U.K., and Euro area.

“Investors who are coming into the new year with concerns about recession might find solace in knowing that broadly diversified ETFs have proved resilient even in the face of economic uncertainty,” said Mr Tieu.

“The diversification and liquidity benefits of broadly diversified ETFs mean they’re inherently lower risk when compared to other investment products, such as individual shares or thematic and complex ETFs”.