As investors in 2022 were battered by global equities (-15.5%) and US investment grade bonds (-13.0%), somebody—lots of somebodies, in fact—took leaps of faith and plowed $604 billion into U.S. ETFs. It was another day, another ETF dollar, and business as usual in ETF land.
Yet closer analysis shows dramatic changes in U.S. ETF investor behavior last year. ETF classifications, references, and time series data show a significant shift in choices across asset classes and investment strategies. For example, loss mitigation replaced performance chasing, and tactical use of bond ETFs surged.
Investors gravitated to complex or specialized strategies, which are more expensive than the core portfolio building blocks that have long dominated the ETF landscape. Yet fee-consciousness prevailed, as investors chose the least costly options that matched their investment goals.
Let’s call the 2022 U.S. ETF investor Prudence. Prudence is a deliberate, defensive bargain hunter. She knows what she wants, and she shops for it carefully. And when prices fall, Prudence buys. Her style shows up in overall flows, asset class preferences, investment strategy choices, and product selection.
U.S. ETF Flows in 2022: Second Strongest Year Ever
Prudence added to her ETF investments despite the market pressure last year. U.S. ETF organic growth measured 8% for the year and 12% for the past five years. The $604 billion of U.S. ETF inflows in 2022 isn’t a high-water mark compared to the record flows in 2021. But it’s a tribute to Prudence’s steady nerves that 2022 brought in the second-highest ETF flows ever.
The chart below provides context, showing annual flow levels since 2016, broken down by asset class.
The biggest variation in ETF flow levels over the past few years has come from equity. In contrast, fixed income flows held steady, just below the $200 billion mark. It’s a remarkably stable picture, suggesting that Prudence took advantage of ETF markdowns.
Strategy Group: Under the Microscope
Overall flows and asset class preferences are easy to measure but understanding Prudence’s choices requires a more sophisticated approach. Detailed ETF classifications pinpoint an ETF’s economic exposure, and investment strategy descriptions allow her to focus down further.
FactSet’s investment strategies fall into four groups:
- Vanilla funds track broad-based, cap-weighted indexes
- Strategic funds, often marketed as “smart beta,” apply well-researched investment and economic principles to security selection and weighting
- Active ETFs have humans at the helm
- Idiosyncratic funds take a non-standard approach, such as ESG, equal-weighting, or exchange-specific selection
Parsing 2022 ETF flows by asset class and investment strategy shows an apparent contradiction: Prudence pivoted away from vanilla strategies when choosing equity ETFs but embraced them for fixed income.
Equity: Winning by Losing Less
Vanilla strategies have long dominated the equity ETF market, with a 64% market share at the outset of 2022. Strategic funds comprised 25%, 2% were actively managed, and idiosyncratic funds took up 8% market share.
2021 equity ETF flows were roughly in line with investment strategy market share, but in 2022 Prudence lost her taste for vanilla investing, directing 61% of her equity dollars to anything but vanilla. She steered clear of sector funds, and she affirmatively chose strategic and active equity.
In contrast to the tactical ETF investors of 2020 and 2021, Prudence chose broad equity products, often with a large cap or high dividend focus. She avoided sector funds and thematic equity, which combined took in just $1.8 billion in 2022, down from $122 billion in 2021. Notably, 80% of sector ETFs employ a vanilla strategy.
Instead, in 2022 Prudence selected strategic equity ETFs that emphasize fundamental analysis and income, as well as active management. These classically defensive strategies claim to offer a softer landing in comparison to plain vanilla exposure or growth/momentum. Her caution paid off as these strategies lost less than their competitors.
As a result, vanilla equity ETFs lost market share, as did idiosyncratic strategies like Invesco QQQ Trust (QQQ-US) and ESG.
Market share changes can be measured by comparing actual flows to the strategy’s expected flows based on starting market share. In 2022, in the two largest equity categories—large cap and total market (including value, growth, and high dividend yield)—vanilla funds came up $46 billion shy, while active management took in $29 billion more than expected.
The chart below compares each strategy’s 2022 excess flows (shown in the red diamonds) to each strategy’s performance (shown in blue and green bars). The mapping isn’t perfect, but the trend is clear enough: The strategies that got hit the hardest, returns-wise, gave up market share to those that offered investors some protection from capital losses.
Prudence may not have been chasing performance, but she favored defensive strategies that outperformed by falling less than average.
Fixed Income: I’ll Pick My Own Poison, Thanks
Prudence fled from vanilla equity ETFs but embraced their fixed income counterparts. While vanilla bond ETFs held 86% market share at the start of 2022, they captured 96% of total bond ETF flows for the full year, reversing recent trends that favored active management.
This might suggest that bond ETF investors had embraced maximalism in passive investing—money piling into the broadest total bond market funds. But that’s not what happened. Instead, bond investors selected precision investments that enabled them to control credit quality and duration exposures. These ETFs cover the full range of securities in their market segment, which is often narrow and precisely defined.
Prudence strongly preferred bond ETFs that avoid credit risk.
The U.S. bond ETF market started 2022 evenly split among major categories, with 35% of assets in government bonds, 30% in corporates, and 35% in broad market ETFs that mix some corporates with Treasuries and other government bonds. The iShares Core U.S. Aggregate Bond ETF, (AGG-US), for example, has about 70% of its portfolio in U.S. government securities.
2022 flows were heavily weighted towards federally backed paper, as 76% went to government bond ETFs. Credit preferences followed suit, with investment grade capturing 103% of flows, counterbalanced by 5% outflows from high yield. Broad credit ETFs captured the balance.
While investors shied away from any kind of credit risk in 2022, there was no such consensus about interest rate risk—flows streamed evenly across maturity horizons. Broad maturity ETFs—they accept, maturity-wise, all the market’s offerings—took in just 23% of 2022 bond ETF flows. That’s about half their market share, which started 2022 at 54%. The lion’s share of flows (77%) went to ETFs that target a specific maturity range.
This thirst for maturity/duration precision yielded some odd results. The most popular bond ETF of 2022 was the iShares 20+ Year Treasury Bond ETF (TLT-US). The third favorite was SPDR Bloomberg 1-3 Month T-Bill ETF (BIL-US). Stalwart Vanguard Total Bond Market ETF (BND-US) sandwiched in between them. AGG-US, the biggest bond ETF, was No. 21 on the popularity ranking.
Bullet-maturity ETFs offer the most precise duration control, as these funds limit their holdings to bonds that mature during a specific year. These niche products comprised just 2% of bond ETF AUM going into 2022, but they attracted 6% of the flows, punching three times above their weight.
Pay for Performance?
Defensive equities and targeted bond maturities are complex strategies that offer investors tons of control. Prudence stepped away from the broadest of broad market funds, preferring to be the master of her own fate. But not, as it turns out, at any cost. She shopped for funds that did the job, well, prudently.
Her preferences drove widespread fee compression in 2022, continuing a multi-year pattern. Asset-weighted average ETF expenses dropped by 0.01% in 2022, down to 0.17%. The comparable price five years ago was 0.23%.
Lower fees were the rule in equity, fixed income, currency, alternatives, asset allocation, and geared funds. Commodity fees were unchanged. Only alternatives funds saw an overall increase in asset-weighted expense ratios.
Investors piled into cheaper ETFs in nearly every strategy group within equity and fixed income. Actively managed equity ETF fees plummeted 10 basis points to 0.38%, less than half the 2019 level. Active fixed income ETFs followed suit, falling by five basis points to 0.37%. Other strategy groups had more modest fee adjustments, as shown in the charts below.
Within equity, 18 of the 27 strategies’ asset-weighted expense ratios fell. The largest strategies—those that ended 2022 with $10 billion or more in assets—were clearly vulnerable. Seven saw average fees drop, three saw them rise, and five were flat.
Active management in equity ETFs cost five times the price of plain vanilla as recently as 2020. By the end of 2022, the ratio was 3:1. Perhaps the fee premium will settle out around 2:1, as it has for most other non-vanilla equity strategies.
Market Share Shakeups
Prudence’s preferences showed up in market share changes among the largest ETF issuers, both those who specialize in broad-based vanilla and those who focus on complex investment strategies and active management.
The two lowest-cost vanilla ETF providers, Vanguard and Charles Schwab, gained market share, while pricier Blackrock and State Street fell behind.
Strategic and active ETF purveyors’ gains were also correlated with competitive fees. JPMorgan Chase and Dimensional Funds increased their market share by 0.38% and 0.49%, respectively, offering products that cost, on average, 0.24% and 0.23%, respectively; mutual fund conversions accelerated the increase.
Pricier rivals First Trust and ARK lost market share. Performance may have also tipped the scales, as the average First Trust and ARK equity fund lost 18% and 62%, respectively, while JPM and Dimensional limited the damage to 11% and 13%, respectively.
How Will Prudence Do This Year?
Some of Prudence’s 2022 choices may disappoint in 2023, especially if equity and bond markets stabilize and the defensive and yield-oriented equity strategies that cushioned 2022’s market losses fall behind. After all, active management has historically underperformed broad market exposure, and strategic funds have widely failed to produce long-term risk-adjusted outperformance.
While she might regret her specific market segment or investment strategy choices, she will probably continue to benefit from the expense savings that result from favoring asset management firms with competitive fees. Once markets recover, she will likely celebrate her choice last year to buy stocks and bonds when they went on sale.
Originally published by FactSet on 26 January 2023.
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