ETF Investors Chase Risk Despite Defensive Signals

by: David Fabian


Small cap stocks and international equities are drawing the lions share of new money from ETF investors this year.

Investors are continuing to chase risk rather than add to defensive holdings.

Further upside gains in stocks need to be fueled by positive economic statistics and earnings reports that support higher prices.

One of the benefits of ETF investing is that the landscape is so transparent. Every ETF investor knows exactly what they own at all times and you can get remarkable statistical data from a variety of online sources that track fund metrics.

In screening asset statistics at recently, I noticed that the top 10 largest recipients of new fund flows this year are skewed towards small cap and international equity funds. The largest recipient of new money is the iShares Russell 2000 ETF (NYSEARCA:IWM), which has posted a net gain of nearly $2 billion in 2014. Not to be outdone, the leveraged ProShares Ultra Russell 2000 (NYSEARCA:UWM) was right in the middle of the pack with an additional $1.6 billion in new money.

It's not surprising to me that investors are continuing to add to high beta areas of the economy after a run like we experience in 2013. That is pretty typical risk-on behavior in the midst of impressive resilience in domestic stocks. Adding exposure to international stocks also makes sense considering that foreign equities haven't had the same move higher as the U.S. and may present a pocket of value or diversification strategy.

However, it's worth noting that successive highs in the equity markets appear to be slowing perceptibly and we are starting to see signs of defensive posturing in key areas. The iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) and SPDR Gold Shares ETF (NYSEARCA:GLD) are both areas that have come on strong this year as defensive hedges. Both of these sectors have been established safe havens at one time or another during periods of equity volatility. TLT has gained 4.90% and GLD has gained 13.74% year-to-date through March 11. IWM has gained just over 2% during the same time frame.

What is also interesting is that we have yet to see a significant return of asset flows in these defensive areas. Both GLD and TLT have added approximately $600 million in net new money which is just a fraction of the tens of billions they lost in 2013. That leaves a great deal of room for additional upside if we start to see fear in the marketplace.

What this data points to is that investors are more likely to chase recent performance than look for areas of value or hedge their equity bets with non-correlated positions. It's a tale as old as time and one that is likely to be repeated with every market cycle.

This year we are going to witness how the markets react to the Federal Reserves' exit from their quantitative easing efforts and how it will translate to equity, bond, and commodity prices. The release of stimulus as a bid for the economy will give us a better sense of whether this market can sustain its upside momentum or if we will experience additional volatility. Further upside gains in stocks need to be fueled by positive economic statistics and earnings reports that support higher prices.

I am more inclined to put new money to work at these levels in low volatility sectors or broad-based ETFs that offer more security than small cap stocks. Two funds that come to mind are the iShares MSCI U.S. Minimum Volatility ETF (NYSEARCA:USMV) and the PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV). These defensive funds still offer upside participation if stocks continue to rise and may insulate your portfolio from a more pernicious decline if momentum wanes.

No matter how things shake out this year, I recommend that you stay flexible, diversified, and balanced with your portfolio. The ability to side step volatility while still taking advantage of attractive opportunities will serve you well in your investment endeavors this year.

Disclosure: I am long USMV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: David Fabian, FMD Capital Management, and/or clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities.

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