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By Michael Rawson, CFA

On the heels of a strong December, ETFs brought in $28.6 billion in January, leading to the strongest two consecutive months of flows into ETFs ever. This extends the streak of monthly inflows into ETFs to 20 months.

Flows were driven by international-stock ETFs, where diversified emerging-markets funds have been particularly strong, averaging a record $6 billion over the past two months. Flows into sector stock ETFs picked up in January allowing financial and real estate sector ETF assets to hit record levels. Flows into U.S. stock ETFs moderated somewhat. It appeared that in January, traders pulled money out of SPDR S&P 500 (NYSEARCA:SPY) that had gone into that fund in December. Taxable and municipal bond ETF flows have weakened sharply in the past two months but remain in positive territory.

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Battle of the Emerging-Markets ETFs
At the fund level, iShares MSCI Emerging Markets Index (NYSEARCA:EEM) topped all ETFs with a $3 billion inflow. The fund appears to have benefited from Vanguard's decision to switch index providers to FTSE from MSCI. Since October, EEM has attracted $11 billion in net flows, while Vanguard FTSE Emerging Markets ETF (NYSEARCA:VWO) has attracted less than $1 billion. The iShares ETF had been the largest emerging-markets ETF, but VWO usurped the lead in early 2011 as it had better performance and an expense ratio that is 0.49% lower. As recently as last September, VWO had $20 billion more in assets than EEM, but EEM has been able to claw its way back to within $10 billion of VWO in just four months.

In a sign that traders are taking on more risk, iShares Russell 2000 Index (NYSEARCA:IWM) brought in $1.3 billion in assets. The small-cap Russell 2000 Index has a beta of 1.3 to the S&P 500 Index, and IWM is one of the most-liquid ETFs available, allowing traders to quickly gain access to small-cap stocks.

WisdomTree Japan Hedged Equity (NYSEARCA:DXJ) brought in $1.2 billion for the month, bringing total assets in the fund to $2.5 billion. The Japanese yen has weakened to multiyear lows as Prime Minister Shinzo Abe has called for a weaker yen and more monetary stimulus from the Bank of Japan.

At the firm level, iShares led all ETF firms with $12.7 billion of inflows, while Vanguard took in $10.3 billion. State Street saw $3.4 billion of outflows, brought down by the $6 billion outflow from SPY and a $1 billion outflow from SPDR Gold Shares (NYSEARCA:GLD). Monthly flows into the $125 billion SPY, which celebrated its 20th anniversary last month, tend to be quite volatile and not a good predictor of future flows.

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While pundits have been eager to claim the start of a great rotation into U.S. stocks and out of bonds, the data do not fully support that view. Flows into equities have been strong, but there has not been a rotation out of bonds, at least not on average. In addition, it is emerging markets leading the charge, rather than U.S. stocks.

While iShares saw a large outflow from its taxable bond funds, other providers such as Vanguard continued to have inflows in that category. iShares Barclays 3-7 Year Treasury Bond (NYSEARCA:IEI) had redemptions of $1 billion. Longer-term interest rates rose slightly during the month, leading to a negative 0.5% return in the ETF. Time will tell whether the outflow from bond funds on behalf of iShares investors is the start of a trend of outflows from fixed income. Vanguard's ETF flows tend to be very stable. Over the past five years, Vanguard ETF flows have been positive each and every month, while iShares has had 14 months in which flows were negative.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.