How much are exchange traded funds to blame for October’s US equity market volatility, and what can capital flows here tell us about current investment trends? As the old supermarket tabloid tagline went, “Enquiring minds want to know…”
Let’s start with a little myth-busting: contrary to popular opinion, ETFs do not own sizable chunks of headline names like the FAANG stocks. Total ETF ownership of Facebook, Apple, Amazon, Netflix and Google averages just 6.1% of shares outstanding according to data from industry source www.xtf.com. While ETFs are only a portion of total “passive” invested capital, their specific impact on both stock valuations and intraday volatility is arithmetically small.
Now, if you want to see where ETFs make more of a difference to US stock prices, dig past the top 1,000 names by market cap and look at the Russell 2000 or the S&P 600. The largest name in the Russell (teen retailer Five Below) is 12.3% owned by ETFs. The largest weighting in the 600 (defense/commercial IT company CACI Intl) is 17.8% owned by ETFs. Now we’re talking about real money…
That’s a good segue to a discussion of October ETF money flows, because US equity small cap ETFs saw sizable redemptions this month relative to large caps. The numbers:
- For October-to-date, ETF investors sold down a net $1.2 billion of small cap US equity products. Over the same period, they actually added $1.1 billion of capital to US large cap ETFs.
- This reversed the Q1 – Q3 trend of outsized inflows into US small cap ETFs, which averaged +$2.5 billion/month. Those inflows were, until this month, basically equal to the +$2.7 billion/month for US large caps but obviously on a much smaller base of market cap.
Key takeaway: if you’ve wondered why US small caps rolled over so hard in October, look no further than ETF money flows. We noted yesterday that US small caps have underperformed the S&P 500 by a 2-standard deviation differential in the last 90 days. We like them here, but their near term action seems to be in the hands of ETF asset allocators.
Moving on quickly to 5 other important points on ETF money flows:
#1. ETF investors turned positive on US stocks in the last week. Total US equity money flows are actually positive month-to-date by $814 million, but only because of +$7.3 billion of inflows in just the last week. That means prior to the last 5 days, ETF investors were large net sellers. Still… They are back, at least for now.
#2. ETF investor bias in US equities is now solidly in the “Value” camp.Month-to-date, Value-style ETFs have received $2.0 billion in fresh capital, as compared to $756 million of outflows for Growth funds. Over half ($1.3 billion) of that Value money came in just the last 5 days.
#3. October’s volatility pushed ETF investors offshore and into developed economy equities. Month-to-date inflows here total +$3.3 billion, well above the $814 million for US stocks noted above. This slowed in the last week, however.
#4. Japanese equities saw the largest chunk of these non-US flows in October, with $2.3 billion of fresh capital. This reversed a trend towards redemptions of Japanese equities in the first three quarters of 2018.
#5. The single weirdest thing about this month’s ETF money flows: fixed income products saw redemptions, even in a macro “risk off” environment.A few data points here:
- Month-to-date bond fund outflows total -$2.5 billion, as compared to +$7.6 billion/month of inflows for Q1 – Q3.
- Corporate debt ETFs took the hit, seeing $5.0 billion in redemptions this month-to-date.
- That capital went right into sovereign debt funds, with $4.4 billion of inflows MTD.
- ETF investors also reduced duration risk in October, adding $7.4 billion to short term (less than 3 year) funds while selling down $4.0 billion of explicitly long-dated bond products.
Summing up with one top-of-the-house observation: October’s volatility significantly chilled the environment for ETF flows.
- From an average $23 billion/month from January-September, October will likely come in closer to $4-5 billion (it was $3.3 billion through yesterday).
- The money flows sloshing around this $3.5 trillion pool of capital during October gravitated to de-risking in both bonds (shorter durations, higher quality) and equities (out of small cap/into large, Value over Growth).
All this sets up a November-December US equity market where either volatility rapidly declines (reigniting animal spirits and fresh inflows) or October’s churn is the new normal (more bond de-risking/Value/Growth rotation). At present, we are in the latter camp. October was a wake-up call for US investors, as the ETF flow data clearly shows. We remain positive on US equities, but expect more volatility in the coming weeks before things finally settle out. Psychology doesn’t change just because the calendar does.
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