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By Michael Rawson, CFA

U.S.-listed exchange-traded funds attracted $188.4 billion in 2013, just shy of 2012's record $190.1 billion haul. Those inflows represent a growth rate of about 14% of beginning assets compared with the projected growth of about 3% for long-term mutual funds. Strong inflows, combined with market appreciation, have allowed ETF assets to hit $1.7 trillion, or about 13% of long-term mutual fund and ETF industry assets. Let's take a look at some things we can learn from these strong ETF flows.

ETF Investors Are Different From Mutual Fund Investors
Interest in emerging markets has been strong over the past decade, thanks to improving economic fundamentals and soaring stock markets. Naturally, investment flows have followed. The investment prospects for emerging markets dimmed in 2013 as the bull market in commodities ended, the Fed's talk of tapering created liquidity concerns, and developed-markets' economies improved. Investors following a tactical, market-timing model would likely have sold emerging markets, whereas long-term investors should have rebalanced into emerging-markets stocks. ETF investors sold roughly $6.6 billion out of funds in the diversified emerging-markets category while mutual fund investors bought $39.0 billion. ETFs such as Vanguard FTSE Emerging Markets (VWO) and iShares MSCI Emerging Markets (EEM) are heavily owned by institutions, at least 65% for each. In contrast, it is likely that the mutual funds are predominately owned by individual investors.

ETFs Hold Up Remarkably Well in the Face of Massive Redemptions
Any time a new structured financial product comes along, you should be skeptical, particularly of those created by banks that can easily tilt the playing field in their favor through complex pricing terms and legal jargon. But this skepticism can also be taken too far, in my opinion. A case in point surrounds the issue of whether there is enough physical gold to back the SPDR Gold Shares (GLD). One version of the conspiracy suggests that the gold backing SPDR Gold Shares is not actually in the vaults. It is always difficult to disprove a conspiracy theory, but strong evidence of the stability of the ETP structure was provided in 2013. Slow but steady economic improvement, benign inflation, and signals from the Fed that the printing press would eventually be shut deflated the fear bubble and the fear trade's favorite asset: gold. 17,766,650 ounces of gold exited the vaults of GLD in 2013. In just one week in April, 1,503,272 ounces was pulled out. All the while GLD traded without interruption or a significant premium or discount. Gold bulls may not have liked the result, but neither did the "your ETF might collapse" conspiracy theorists.

Bond Investors Look to Bond ETFs for Liquidity
The sharp rise in interest rates and selling from bonds funds in June was instructive as to the way that institutional investors use bond ETFs. Outside of Treasury securities, bonds are relatively illiquid. Bonds trade at wider bid-ask spreads and it is often difficult to find any ready and willing buyer, let alone enough buyers to facilitate a competitive market. However, bond ETFs have proved themselves relatively liquid. I have heard anecdotes that some bond portfolio managers keep of their junk-bond allocation in slug of their portfolio in iShares iBoxx $ High Yield Corporate Bond (HYG), in case they need to raise cash quickly without having to take a haircut by selling an individual bond. Trading volume in HYG more than doubled in June when interest rates spiked and price deviations from NAV widened. Ownership statistics support the hypothesis that investors were using HYG as a source of liquidity.

Flows by Category Group
Equity ETFs drove the charge in 2013, led by inflows of $97.7 billion for U.S.-equity ETFs, followed by inflows of $56.5 billion for international-equity ETFs and $44.7 billion for sector equity ETFs. 2013 was the first calendar year in which any ETF category group had outflows for that year. In 2013, commodities funds experienced outflows of $29.5 billion, while municipal-bond ETFs bled $253 million. Assets in municipal-bond ETFs are still small relative to assets in municipal-bond mutual funds. At the category group level, ETFs had inflows into taxable-bond funds as outflows from several categories were more than offset by inflows to other categories.

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Flows by Category
Large-blend led all categories, with inflows of $47.6 billion. The category contains the market-cap-weighted passive index funds such as S&P 500 Index funds, so it continues to benefit as investors shift from active to passive management. The improving economy in Europe, which exited recession territory earlier in the year, and the aggressive stimulus in Japan attracted new money to foreign developed markets. The category's $19.3 billion inflow was the strongest since a $12.8 billion inflow in 2007, before the European debt crisis.

The big flow story across mutual funds and ETFs for 2013 was the rotation out of bond funds with mostly interest-rate risk and into shorter-duration products or products with other risk factors, such as credit risk, that were perceived to be more defensive against a rise in interest rates. Compared with mutual funds, the outflows from bond ETFs were less severe in some cases, such as in the intermediate-term bond category. But in some other niche categories, outflows were stronger from ETFs, such as in the long-term bond category.

The short-term bond category led the taxable-bond category group in terms of flows. Among short-term funds, Vanguard Short-Term Bond ETF (BSV) attracted $4.8 billion. PIMCO Enhanced Short Maturity ETF (MINT) attracted $1.7 billion, bringing assets to $3.9 billion and making it the largest active ETF, while PIMCO Total Return ETF (BOND) had outflows of $197 million, dropping assets to $3.5 billion. On an organic growth basis, funds in the bank loan category had the fastest growth and were led by PowerShares Senior Loan Portfolio (BKLN).

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Smart Beta Gains Recognition in 2013
Although Morningstar does not have a separate category for so-called "smart beta" funds, they can be identified by their characteristics, such as using non-market-cap weighting or emphasizing less-traditional risk factors. Using a broad definition of the term, Morningstar counts 249 funds with the smart-beta theme with assets of $277.9 billion, up from $179.1 billion a year ago. Inflows of $46.0 billion in 2013 represent a 26% organic growth rate, faster than the 20% organic growth rate of U.S.-equity ETFs.

Flows by ETF
SPDR S&P 500 (SPY), the largest ETF, attracted the greatest inflows in 2013 and brought assets to $174.8 billion. But SPY continues to slowly lose market share to both iShares Core S&P 500 (IVV) and Vanguard S&P 500 ETF (VOO). SPY returned 32.21% for 2013, while IVV returned 32.31% and VOO returned 32.33%. Although SPY is more liquid, it charges more than both IVV and VOO and uses a less efficient unit investment trust legal structure. WisdomTree Japan Hedged Equity (DXJ) benefited from both a falling yen and a rising stock market in Japan. The fund returned 41.86% in 2013 and had inflows of $9.8 billion. Assets hit $12.6 billion, up from just $1.2 billion a year ago. DXJ's success spawned a number of currency-hedged equity ETFs in 2013.

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Flows by Provider
Vanguard led all firms with a $55.1 billion inflow and continued to gain market share, albeit at a slower pace than in the past. Among smaller ETF providers, PowerShares, WisdomTree, Guggenheim, First Trust, Schwab, ALPS, and FlexShares each made significant gains in market share. Flows to PowerShares were driven by strong demand for bank-loan funds as well as interest in its flagship, PowerShares QQQ (QQQ). Strong equity market performance helped First Trust gain share, as a high percentage of the firm's funds are equity funds. ALPS benefited from continued interest in MLPs. Those losing market share included iShares, State Street, and Van Eck. While iShares gained from strong flows to the international-equity category group, it lost share within the taxable-bond category group. Van Eck's lost market share was a result of strong outflows from Market Vectors Gold Miners ETF (GDX), Van Eck's largest exchange-traded fund.

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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.

Source: 3 Lessons Learned In 2013 From ETF Fund Flows