Flow & Tell with iShares | February 2023

February ETF heat map

February ETF flows compared with index performance

ETFs attracted little love in February as the Bloomberg U.S. Agg clocked its worst month since September and all three major equity U.S. indices sank to finish the month in the red (and not the good, Valentine’s Day hue).¹ U.S. listed ETFs added a modest $8.3 billion across all asset classes, a 79% drop from January’s total flows, and an 89% plunge from the previous February’s inflows.² On an absolute basis, it was the smallest monthly change in total assets since the pandemic.³

Despite the muted activity, February’s poor market performance did not translate to outflows even amid fears of higher for longer interest rates thanks to surprisingly strong economic data that solidified hawkish monetary policy expectations. Ten of the S&P 500’s eleven sectors closed the month with losses as broad-based declines pulled the index lower.⁴ Equity sector ETFs were unsurprisingly the laggards of the month, contributing $3.9 billion of outflows in aggregate. Bonds slumped lower in tandem, in an unwelcome throwback to 2022, badly battered as U.S. Treasury yields climbed to 3-month highs.⁵ Still, flows did not follow performance: ETFs collected modest inflows even as the market reversed course from January’s unexpectedly (and perhaps unjustifiably) strong performance. Equity funds added $6.0 billion alongside $2.8 billion into fixed income ETFs.⁶

Recent fund flows have shown a pronounced rotation from domestic equities into fixed income, which held true even as the pace of money in motion slowed in February. Higher inflation data and stronger economic indicators prompted a reset in rates and widening of credit spreads. Investors responded by allocating to Treasury ETFs, primarily at the front-end of the curve. SHV (iShares Short Treasury Bond ETF) was the top ETF asset gatherer in February, adding $4.5bn for its largest monthly inflow on record.⁷

But fixed income flows in February told another story as well. Examining just which funds suffered outflows and which captured inflows likely reveals divergent preferences between fast money traders and longer-term investors.

In total, fixed income ETFs netted $2bn in February, a far cry from the more than $20bn added in January.⁸ Under the hood, however, the bulk of outflows were concentrated in a small handful of funds. Flagship credit funds LQD (iShares iBoxx $ Investment Grade Corporate Bond ETF) and HYG (iShares iBoxx $ High Yield Corporate Bond ETF), both among the most highly traded funds in their asset class, each experienced outflows of more than $5bn — reflective of both the prevailing risk-off sentiment as well as their use as popular hedging vehicles among institutional investors.

Inflows, on the other hand, were spread across a larger number of funds and a wider range of exposures. Funds more often associated with longer term holding periods had banner months. That divergence — sharp outflows from trading vehicles coupled with strong inflows to asset allocation ones — may simply suggest a difference in investment horizon, where long term investors see opportunity to lock in higher yields, while high frequency traders fret about near term volatility. The commonality? Both investor types used ETFs to help position their portfolios.

After a supportive start of the year for emerging market (EM) exposures, 2023's macroeconomic picture quickly soured after stronger than expected inflation and labor market data raised Fed Funds expectations. EM ETFs have been a popular choice for many investors looking to diversify their portfolios as the U.S. dollar weakened from a peak in September. In January, EM ETFs added $11.7 billion while investors priced in higher possibilities of a Fed rate cut at the end of the year and inflation expectations decreased.⁹

Fast forward to February and surprisingly strong Consumer Price Index data for January, which rose 0.5% month-over-month, and a red-hot payrolls report drastically changed investors’ Fed policy expectations.¹⁰ U.S. Treasury yields surged in February and investors priced in a higher terminal rate, contributing to a rally in the dollar. As the dollar strengthened, flows into EM exposures in February turned net negative with EM ETFs seeing $981 million of outflows.¹¹ That marked a sharp reversal — EM ETFs have gathered assets for each of the last four months as the dollar declined.

One thing is clear: flows have been closely tied to the dollar. We could continue to see outflows from EM ETFs as the strong dollar makes international exposures less attractive. But we believe any potential weakness in the dollar could make EMs an enticing option again.