No Time For Heroics: ETF Investors Look For Cover

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Includes: IEMG, SLQD, USMV
by: Martin Small

The economy and corporate earnings are humming. Inflation is in check. U.S. stocks are touching records. So why are investors so edgy? ETF flows can help tell the story.

In the early 1920s, football coach Elmer Henderson set the USC Trojans on the path to prominence, ultimately earning the best winning percentage of any coach in Trojan history. Henderson was known as "Gloomy Gus," a nickname he earned for his tendency to bad-mouth his own team's chances before a game. It's unclear whether he was hedging his bets or really worried, but imagining - and preparing for - the worst clearly served him well.

The markets may be going through a Gloomy Gus moment right now. To all appearances, the economy is in great shape. Corporate profits are up, GDP growth is steady, inflation and unemployment are low, and banks are lending. The same rising tide that propelled all global financial assets in 2017 is still in place.

Yet, if we track where exchange traded fund (ETF) owners have focused their dollars this year, there's clearly been a sentiment shift. While investors are staying in the markets, they're also more reticent and adding ballast to their portfolios.

U.S. ETF investors have added more than $205 billion in net new assets this year (through September 28), most of it in large-cap U.S. stocks and Treasury bonds (Treasury purchases have largely been "barbelled," allocated to short- and long-term maturities). Emerging market stock ETFs, which had gathered $42 billion in 2017, have taken in about $11 billion; the bulk of flows have gone to broad indexes and to China. In fixed income, high yield saw more than $4 billion in outflows compared with $4 billion added during the previous year.

In other words, investors are in no mood for heroics. They're leaving their Superman capes in their briefcases and hunkering down at their desks.

Tail wagging the curve

What's making investors so nervous? In a word, it's trade, namely the unknown impact of U.S. tariffs and increased tensions with our longtime partners China, Canada and Europe. In a globalized economy, when one country wobbles, everyone feels it. As a result, while growth prospects have been strong, the left tail of the distribution curve has been getting fatter.

So how can ETF investors help hedge their portfolios for uncertainty while still participating in upside potential? Here are four ideas to consider:

1. Take credit for your bonds.

As the Federal Reserve notches up its policy rate, some investors have been turning to short-maturity bonds: 2-year Treasury yields have offered a similar yield to the 10-year, with substantially lower interest rate risk. For incremental yield potential, think about short-term investment grade credit: the iShares 0-5 Year Investment Grade Corporate Bond ETF (NYSEARCA:SLQD) has a 30-day SEC yield of 3.3% (as of 9/28) compared with 2.8% for the 2-year Treasury and 3.1% for the 10 year.

2. Rethink the role of EM.

Prices for emerging markets stocks, which had a virtually uninterrupted runup in 2017, are off 15% from their highs in January (as measured by the MSCI Emerging Markets Index). Yet flows into broad EM indexes, while less robust than last year, have stayed remarkably steady. That's a mindset shift: ETFs like the iShares Core MSCI Emerging Markets ETF (NYSEARCA:IEMG) are finally being seen by some investors as long-term allocations rather than as risk plays. As I wrote about recently, this latter role is being played by single country ETFs, which makes it easier to express market views on a more granular level.

3. Diversify and tilt your factors.

While factors such as quality, value and momentum have historically outperformed the broader markets over long periods, they tend to move cyclically. Investors may want to consider diversifying across factors, via smart beta ETFs, and "tilting" exposures as needed. This year has seen a massive turnaround in flows to the iShares Edge MSCI Min Vol USA ETF (BATS:USMV) and other minimum volatility products, which aim to help investors stay in the stock market with potentially less risk.

4. Bring sustainability to your core.

Finally, investing through an ESG lens (for environmental, social and governance) can be an innovative way to gain exposure to companies implementing practices that may position them for future growth - from who they hire to planning for climate impacts to securing their data. And for many people, sustainable ETFs align their values with their financial goals.

In his 25-year career coaching college football, Gloomy Gus Henderson ultimately amassed an incredible record of 126 wins versus only 42 losses. If there's a lesson for investors, it's that even in the winning-est conditions, it's worth preparing for surprises. Fortunately, there are ETFs that can help for what's waiting on the field.

This post originally appeared on the BlackRock Blog.