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By Michael Rawson, CFA

Exchange-traded funds drew in $38 billion in new money during September, marking the strongest month of flows in over three years and a sharp rebound from August, which saw an anemic $2.6 billion in inflows.

The U.S.-stock asset class led the way, gaining $18 billion and reversing August's $8 billion outflow. The largest ETF, SPDR S&P 500 SPY led all funds with a $12 billion inflow. Sector-stock funds added $7 billion, while international-stock funds also added $7 billion.

The S&P 500 returned 2.58% in September, given a boost by the Federal Reserve's announcement of additional quantitative easing measures. The Fed's actions are seen as designed to encourage risk-taking and as providing a boost for asset prices.

(click to enlarge)

- source: Morningstar Direct

Within each asset class, the riskiest segments attracted strong inflows last month. Within fixed income, high-yield bonds attracted $1.6 billion in flows. Within U.S. stocks, small caps attracted $2.8 billion. Within international stocks, emerging markets brought in $2.9 billion. Within sector stocks, both real estate and financials attracted more than $1 billion. The Morningstar category with the strongest flows was the large-blend category, which pulled in $12 billion, while intermediate government saw the strongest outflows, losing nearly $1 billion. Speculators may have been betting on the intermediate government category in anticipation of the Fed’s QE3 announcement, as the category’s strong flows in August reversed in September.

Critics of the Fed suggest that this latest move could be inflationary. Commodity precious metals funds gained nearly $3 billion with SPDR Gold Shares (GLD) gaining nearly $2 billion by itself. Treasury Inflation-Protected Securities rallied during the month, with the Barclays US Treasury US TIPS Index returning 0.51% compared with 0.14% for the Barclays US Aggregate Bond Index. Despite that, flows into the category were weak, as $300 million flowed out of iShares Barclays TIPS Bond (TIP). However, both of Northern Trust's relatively new TIPS ETFs, FlexShares iBoxx 3Yr Target Duration TIPS ETF (TDTT) and FlexShares iBoxx 5Yr Target Duration TIPS ETF (TDTF), had strong flows. PIMCO Total Return ETF (BOND) had another strong month, gaining about $350 million as did PIMCO 0-5 Year High Yield Corporate Bond Index ETF (HYS) , a fund that we spotlighted here.

The fact that the Fed's program is targeting mortgage-backed securities should help lower mortgage rates and provide a boost to MBS funds. Mortgage rates hit a record low during the month of 3.4%, while the largest MBS ETF, iShares Barclays MBS Bond (MBB), gained nearly $300.

ETF Price War Continues

On the heels of last month’s announcement that Russell was shuttering most of its ETFs and that Scottrade was exiting the ETF business, Schwab cut the fees on its entire ETF lineup and announced its intention of being the low-cost leader in core index ETFs. Schwab is the 12th largest ETF provider with $7.5 billion in assets in 15 ETFs. Schwab now has the lowest asset-weighted average expense ratio of any ETF provider, at 0.08% compared with 0.14% for Vanguard, 0.24% for State Street, and 0.33% for iShares. Of course, Schwab offers only core portfolio building-block ETFs and not the higher-cost, niche ETFs.

Additionally, Larry Fink of BlackRock announced his intention that iShares would cut the fees on several core index ETFs to better compete with lower-cost products. In the past, when iShares has cut fees, it has typically only been by a few basis points and not enough to make the funds competitive with lower priced funds from competitors such as Vanguard. In every category where the two firms compete head-to-head with ETFs tracking the same index, Vanguard has the lower-cost fund. The only case in which iShares has made a significant fee cut was with iShares Gold Trust, which cut its expense ratio to 0.25% from 0.40%, undercutting its larger competitor, SPDR Gold Shares by 0.15%. Since the cut in July of 2010, IAU has gained a bigger share of flows into gold funds. Also during the month, Vanguard announced that it was switching index providers on a number of funds that track MSCI indexes to indexes provided by FTSE and the University of Chicago's Center for Research in Security Prices.

State Street led all providers with $17 billion in flows for the month, while iShares came in second with $12 billion. Vanguard rounded out the top three with $5 billion in flows. Van Eck garnered a respectable $1 billion behind the strength of Market Vectors Gold Miners ETF (GDX) and Market Vectors Junior Gold Miners ETF (GDXJ).

iShares remains the largest U.S. ETF provider with 40% of the $1.3 trillion in ETF assets. State Street is second with a 25% market share, and Vanguard comes in third with 18%. Vanguard’s market share is up from 16% at the start of the year, while iShares' is down from 42%.

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- source: Morningstar Direct

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Markets Go Risk-On With The Fed's Approval