Flow & Tell with iShares | October 2022

October ETF heat map

October ETF flows compared with index performance

October wasn’t only the month for harvesting apple, squash, or pumpkin (spice lattes). Many investors took the time to tax-loss harvest: an instance in which an investor may sell underperforming assets in order to potentially reduce taxable capital gains. Using the proceeds of the sale, investors generally buy a correlated investment or take the opportunity to switch their allocation makeup. Given widespread poor performance across numerous asset classes year-to-date, opportunities to lock in losses abound.

Municipal bonds were one example where investors may have seen opportunities for tax-loss harvesting in the last month. As the Federal Reserve moved quickly to hike rates, municipal bonds (popular among some investors because of their favorable tax treatment) fell ~12% year-to-date.³ As the space sold off, municipal bond mutual funds saw outflows, while their ETF counterparts added assets to the tune of $6.2 billion during the month of October.⁴ This year alone, municipal bond ETFs have cumulatively added $19.1 billion in net assets, with the majority of flows occurring in May and October.

With the Federal Reserve hiking interest rates to tighten financial conditions, the 30-year fixed mortgage in the U.S. reached a 20-year high of over 7%.⁵ Coupled with quantitative tightening — in which the Federal Reserve is stepping back from mortgage-backed security (MBS) purchases — this has resulted in abysmal performance for MBS indices and significant market volatility.

However, mortgage spreads may look attractive to some investors compared to their own history and given their fundamentals. Spreads on MBS currently sit near post-Global Financial Crisis highs.⁶ Furthermore, the debt-servicing problems of the GFC may not be comparable to today as home buyers have moved away from adjustable-rate mortgages (fixed-rate mortgages make up the vast majority of MBS) and sub-prime loans represent a much smaller portion of the home loan market. As a result, mortgages may offer some multi-asset investors an attractive alternative to investment grade corporate credit given their relative risk profile and strong underlying liquidity.

Already, we’ve seen flows towards MBS ETFs. October saw $2.4 billion flow into the space — a far cry from $2.3 billion in net outflows in the first three quarters of the year. As the Federal Reserve looks to tamp down their hiking cycle, MBS ETFs may be beneficiaries of a clearer and more stable rate market and investors looking to take advantage of relative valuations.

Investors are increasingly looking to build whole portfolio solutions using ETFs, and when some of the largest managers reshuffle their holdings, it can result in ETF flows. Some of these model portfolios rebalance on a quarterly basis, resulting in standout flows in several ETFs in October. One of the primary themes that played out during some of the latest rebalances were a shift back to benchmark in an effort to reduce risk.

When looking to navigate a market sell-off, there are two general approaches that we’ve seen investors take from an ETF flows lens. The first is by limiting ‘beta’: defined as a portfolios expected movement relative to the overall market. In other words, by reducing a portfolio’s market beta, investors may reasonably expect their portfolio to draw down less when markets sell-off. Investors look to reduce beta, and lower their sensitivity to the overall market, may look to low volatility ETFs, which have accumulated nearly $11.0 billion inflows year-to-date — $7.0 billion of which occurred in Q3 alone.⁷

Another way to potentially mitigate risk, particularly for those managing to a benchmark, is to reduce ‘active risk’: defined as a portfolio’s deviation from its benchmark. This minimizes the risk the portfolio may underperform its benchmark during times of uncertainty, with investors preferring to match the benchmark returns and wait for opportunities at a later date.

For instance, a rising rate environment may adversely affect technology firms due to their long-dated cash flows, prompting an initial underweight from an investor. However, as the interest rate regime establishes itself and the initial sell-off has passed, an investor may move back into technology stocks as a means of moving back to their benchmark. In this case, downside risks that were well understood during a changing rate regime were replaced with uncertainty, prompting a move back towards benchmark.

It looks as if some model portfolios took this route during their latest rebalances: adding back in tech exposure in order to move closer to their benchmark: information technology ETFs posted their first month of inflows since March, adding $2.9 billion.⁸