Is There Wisdom in the ETF Crowd?

After taking a breather in August, inflows into ETFs really picked up steam in September. Last month, investors poured more than $25 billion into U.S.-listed ETFs, boosting total year-to-date net inflows to roughly $65 billion. Strong demand from investors as well as advances of 8% and 10% for the S&P 500 and MSCI EAFE in September helped the U.S. ETF industry top $900 billion for the first time.

Each month it is an interesting exercise to observe where investors are putting their money to work, and also what investments they might be selling. There have been a few pronounced trends that have persisted in the ETF flow data for some time now that are worth thinking about. We'll discuss a couple of those trends here and what they are signaling to the markets. But before we dive in, remember that the flow data often contain "noise" and won't always be the best determinant of true investor sentiment.

For that reason, we'll focus more on the clear and broader trends that have recently dominated ETF flows (and mutual fund flows for that matter). For our purposes, we're less concerned with exact dollar figures than we are with capturing general fund flow trends for a perspective on current investor behavior.

Juicy Yields Drive Investors to Junk Bonds
In this low-yield environment, we've seen many ETF investors step out a little further on the risk curve--to junk bonds--in an effort to capture higher yields. While flows into high-yield bond ETFs tend to be a little more volatile than some other fixed-income categories, the trend has been decidedly positive in recent months (and seems to be gaining steam).

Last month, investors poured another $415.7 million into  iShares iBoxx $ High Yield Corporate Bond (HYG), bringing the year-to-date total to $1.9 billion. Similarly,  SPDR Barclays Capital High Yield Bond (JNK) attracted $375.8 million in net inflows last month and $2.1 billion since the beginning of the year. Those less optimistic on the prospects for high-yield bonds might suggest that recent flows smack of performance chasing. While the asset class has rebounded spectacularly from its 2009 lows, we still think there's a solid case to owning junk bonds as part of your fixed-income allocation.

Indeed, after non-investment grade bonds exploded alongside the 2009 market rally, their spreads have compressed from the record highs witnessed during the heights of the financial crisis. With a good portion of the high-yield bond market trading close to par, investors who are piling in at this point of the cycle should be cognizant of the fact that most, if not all, of the positive portion of future returns will come from coupon payments. However, that alone is no reason to scratch the asset class off of your watchlist, considering that junk-bond yields are currently hovering around 10%. If you're in the camp that believes that, going forward, the average return for equities will be in the low single-digits, then a 10% yield is certainly nothing to sneeze at.

Default risk should be the primary concern of investors getting into junk bonds at this time. Despite growing economic uncertainty and stubbornly soft labor markets, there is room for optimism on this front. First, the corporate sector should benefit from the generous helping hand of the government (that is, a monumental dose of fiscal and monetary stimulus). Access to low-cost funds has helped many firms recapitalize and shore up their balance sheets. This "lifeline" allowed many firms to survive the darkest days of the crisis. While non-investment-grade firms will likely face some challenges ahead as a result of an uneven economic recovery, it's hard to dispute the fact that they are in far better shape today than they were 18 months or so ago.

Some might even be surprised that non-investment-grade bond issuances are on pace to top the all-time high recorded in 2009. (The massive parade of credit downgrades during this period likely helped contribute, but that's beside the point.) This is significant in that we're seeing many firms taking advantage of current accommodations to refinance at lower rates and extend their debt maturities. Such activity bodes well for high-yield issuers, as they can better avoid potential liquidity constraints and maintain healthy balance sheets in anticipation of recovering demand. Investors here don't need the economy to go gangbusters for their junk-bond exposure to pay off. Even a "muddle through" recovery would be fine, as we care only that the company stays in business and can service its debt payments.

TIPS--Not So Popular Anymore
After 30 consecutive months of inflows,  iShares Barclays TIPS Bond's (TIP) extraordinary streak came to an end in March of this year. Since March, investors have yanked more than $1 billion out of TIP, of which $673 million was redeemed in August and September. The original thesis was that the explosion of the Federal Reserve's balance sheet would lead to a bout of inflation down the road. However, the velocity of money remains subdued and the inflation scenario has turned into more of a longer-term story. In the near term, the concern has actually turned to deflation, which might have led some to pull back on their Treasury Inflation-Protected Securities exposure.

Surely there's a place for TIPS in the bond portion of any portfolio, but it's worrisome to hear that many investors were "backing up the truck" on TIPS. The case for an inflation-protected investment strategy is to preserve the purchasing power of one's savings. TIPS achieve this through principal adjustments based on changes in the CPI. But, it's worth noting that owner's equivalent rent has increased to 24% of the reported CPI figures and has a disproportionate influence on this statistic. Something to consider is that many investors own their homes and have seen other daily expenditures (such as energy and food prices) rise.

In our view, there seems to be a relationship between the decreased popularity of TIPS and the increased popularity of commodities, REITs, and dividend-paying stocks. Owning hard assets could be another good inflation hedge, but we caution investors not to lean too far in one direction. Remember that TIPS are government-backed securities that exhibit much lower volatility than commodities or REITs. For many investors, particularly those nearing retirement, the defensive nature of TIPS is a benefit that should not be overlooked.

Precious Metals Shine
The gold rush is still on. But, in terms of fund flows, it was a silver ETF that shone brightest in September. Last month,  iShares Silver Trust (SLV) saw more than $420 million in net inflows. Leading the physical gold bullion ETF pack was  iShares Gold Trust (IAU), which recently dropped its fee to 0.25% to better compete with the mammoth  SPDR Gold Shares (GLD), which charges 0.40%. The three major gold funds--GLD, IAU, and ETFS Physical Swiss Gold Shares (SGOL)--saw combined inflows of approximately $465 million last month.

In comparison to gold, silver is not a perfect substitute. Silver's industrial uses make it a much more dilute "safe haven" asset than gold and a less effective hedge against inflation. If companies that use silver in their manufacturing processes scale back production, silver prices are likely to suffer. The prices of these two metals have exhibited a correlation of 0.73 over the last 10 years and do not move in lock step. As of this writing, gold prices are roughly 63 times greater than silver per ounce, and gold has averaged a ratio of 61 times higher than silver over the last decade. The range has been from 81 times to 44 times higher over the same time frame. To put that in longer-term perspective, gold was fixed at 16 times higher than silver until the gold standard was abandoned, and gold tended to trade at about 40 times more than silver for the decades following that event.

Whether you go with gold or silver, we always like to remind investors that unlike equities or bonds, commodities are nonearning assets that are worth only what another party is willing to pay. That said, they do offer diversification benefits within a broadly diversified portfolio. When considered as a long-term core holding, we recommend keeping only a small allocation to precious metals, if at all. Our research suggests that a 4%-10% total weighting for all direct commodities exposure is sufficient, and the majority of that weighting should be split among energy, agricultural, and industrial and precious metals. That said, we wouldn't be opposed to tactically owning precious metals periodically as a satellite holding as an inflation hedge or store of value during periods of currency valuation uncertainty.

Fund flow trends can reveal interesting themes. But the crowd isn't always right. As always, it's important to consider our own individual circumstances and goals before deciding to go with, or against, the crowd.

Don't Miss Morningstar's ETF Webcasts, Dec. 14, on BrightTALK

Generating Income with ETFs and Shielding from Inflation
with Paul Justice, Associate Director of ETF Research for Morningstar
This presentation will give an overview of the current state of the markets and how ETFs can be used for income generation and to reduce the impact of inflation. Paul will also discuss the unique features of some ETFs commonly used for those purposes.

Building a Strategic Portfolio with ETFs
with Michael Rawson, ETF Analyst, Morningstar
This presentation will give an introduction to ETFs and describe how they can be used to build a strategic asset allocation.

Click here to register.

Also presenting:

Industry Trends and Using ETFs to Implement Asset Allocation
Deborah Fuhr, Global Head of ETF Research & Implementation Strategy, BlackRock

You will be able to attend any or all of the presentations in this complimentary summit, submit real-time questions to presenters and vote in audience polls during the live webcasts. If you are unable to attend the webcasts live, you can also view them afterward on demand.

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