Washington Woes Drive ETF Flows

 |  Includes: CSJ, FLOT, IFEU, IYE, IYW
by: Dodd Kittsley

With the constant barrage of news reports discussing the Fed's actions, the government shutdown and the debt ceiling debacle, it's little wonder what's preoccupying the minds of investors these days. A quick look at ETF flows over the past few months paints a picture of an increasingly uncertain investor population reacting - almost real-time - to each new development out of Washington.

The chart below illustrates how net global ETF flows have been riding the policy rollercoaster this year. Accommodative Fed actions and comments prompted a surge of investment in May, July and September; however, each month was followed by outflows or suppressed inflows as the good news wore off and uncertainty set in again. Most recently, Washington's woes have again caught up with the market, with October inflows suppressed to the tune of $1.8 billion occurring in the first two weeks of the month (through Oct 14th). It appears that investors are once again taking a "wait-and-see" approach.

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The majority of month-to-date outflows have been in the fixed income category (-$3.7 billion), offset by developed equity inflows of $6.6bn. We have seen similar suppressed activities in long-term equity mutual funds. As of Oct 9th, equity mutual funds had 2-week outflows of -$3.8bn, whereas bond mutual funds had $0.5bn of inflows. That compares with much more decisive activities last October - equity mutual fund outflows of -$17.0bn and bond inflows of $56.1bn.

As far as the debt ceiling goes, "wait-and-see" investors may not have to wait much longer, since it appears that grudging progress toward a deal is being made. However, the fix is likely to be short-term. This "kick-the-can" policy approach essentially ties investors' hands, since it can be tempting to wait for a resolution before getting back into the market. But if the past year of policy-driven markets has taught us anything, it's that what we're seeing now may just be the new normal. And staying out of the market for too long can have potentially negative consequences of its own.

So how are investors using ETFs to stay invested in this new world of uncertainty? On the fixed income side, we've seen a massive "duration rotation" this year as many investors prepared for an eventual interest rate hike. Short maturity credit (NYSEARCA:CSJ) and floating rate notes (NYSEARCA:FLOT) in particular have been beneficiaries of this trend toward shorter duration funds. On the equity side, within the U.S. equity category we're seeing more and more people take a tactical approach to sector investing, rotating out of defensives and into select cyclical sectors, such as energy (NYSEARCA:IYE) and information technology (NYSEARCA:IYW). We have also seen increased demand for developed market equities outside the U.S., with a recent strong preference for pan European equity exposure (NASDAQ:IFEU).

Sources: BlackRock, Bloomberg, EPFR

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