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If I were a betting man, I’d bet that “fiscal cliff” was the most frequently used phrase of December 2012. From countdown clocks to special reports, the media covered the approaching fiscal cliff 24 hours a day, seven days a week. For investors, there was no way to escape the endless speculation as to what hurtling over the fiscal cliff could mean for the stock market, and what possible changes in tax laws could mean for personal investment portfolios.

Well, it’s 2013 and while the fiscal cliff has come, it has not yet fully gone. Congress did agree to a bare bones deal to delay the fiscal cliff. But as my colleague Russ Koesterich has noted, the deal fails to address the longer-term fiscal challenges facing the United States and uncertainty continues to linger over the debt ceiling. Russ expects the deal will damper short-term US consumption, and he is forecasting a modest fiscal drag on the US economy early in the year.

So, how is this political wrangling being reflected in ETF flows?

In December, a month when investors typically position portfolios for year-end and the start of a new year, investors followed a risk-on pattern. Investors favored US large cap and emerging market equity exchange traded products (ETPs), while withdrawing funds from US Treasury ETPs. Worries over the fiscal cliff may have influenced high dividend ETPs, which saw redemptions of $0.1bn in December. It was the first monthly outflow for the category in more than two years.

With the political situation still uncertain, Russ has told investors to prepare for a rocky road over the next three months. By the end of March, Congress must contend with the debt ceiling, confront an estimated $108 billion in spending cuts and pass additional legislation to fund various government entities. What might this mean for ETF flows in the early part of this year?

First, we would expect that US large and mega cap equity ETPs, which are generally less sensitive to domestic growth, could garner favor with investors. But small and mid cap stocks have historically been the most exposed to domestic growth, and these ETP categories could be vulnerable.

Second, international markets could garner favor with investors. In December, emerging market equity ETP flows hit a new monthly high of $13.1bn, and we saw broad emerging markets ETPs end the year on a seven-month inflow streak. With Russ expecting slower US growth and more volatility in the near-term, segments of the international market most levered to global growth such as emerging markets, smaller developed countries and peripheral European exporters could benefit from the current environment.

Third, with the Federal Reserve expected to keep interest rates low for quite some time, we expect to see continued flows into higher yielding fixed income categories. This also means a continued aversion to US Treasuries, as even a modest increase in yields would have a significantly negative impact on Treasury prices.

And in the early days of 2013, it appears that investors are reversing their stance on high dividend ETPs. In contrast to the outflows seen in December, $647 million has flowed into these funds through January 10th.

Sources: BlackRock Investment Institute, Bloomberg, National Stock Exchange (NSX)

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Source: 3 Implications For ETF Flows In A Policy Driven Market