‘Pre-packaged diversification’ an attraction for investors in volatile market conditions.

In the midst of the COVID-19 pandemic, there has been a surge in capital inflows from retail investors into Exchange-Traded Fund (ETF) products. More than $8 billion of funds has flowed into ASX-quoted ETF products this year. Flows have accelerated since mid-March when financial markets began to rebound after February’s sharp falls.

These inflows have taken total funds under management across the Australian ETF sector to over $65.5 billion, spread across more than 200 different products that cover Australian and international shares, niche equity sectors and strategies, fixed-income securities and other asset types.

Although the use of specialist ETF products for higher-risk, short-term trading strategies has increased, the bulk of transactions continue to be linked to index products tracking the broader Australian sharemarket and major international markets, primarily the United States.

Of course, what’s happening in the Australian context is not unique. More than $400 billion of capital has flowed into ETFs globally since March, taking total sector assets to almost $9 trillion.

So, why has this deluge of capital into ETFs been occurring?

In many ways, the rapid inflows into ETFs over recent months are further evidence of investment trends that have been underway for some time. There’s no doubt they have been amplified as a result of the unsettling market events triggered by COVID-19, but what’s occurring also represents a broader shift in the way that many retail investors choose to invest.

Acceleration to diversification

The strong and increasing gravitation towards ETFs – by investors directly, and channelled through financial advisers and stockbrokers – reflects a growing awareness among investors around the importance of portfolio diversification in helping to dampen market volatility and reduce overall exposure risk.

So, it’s no great surprise that during these more volatile conditions there has been an acceleration of inflows into ETFs.

ETFs effectively offer “pre-packaged diversification” by virtue of providing broad exposures across different asset classes, sectors and regions usually to hundreds, and sometimes thousands, of underlying securities within a single low-cost product structure. That’s their key attraction, and investors have collectively diverted large amounts of capital into ETFs as a way to capture discounted market prices and to diversify and de-risk their portfolios at the same time.

There has also been another related investment trend on show, and that’s the increased use of ETFs by investors for portfolio-management purposes as a result of the sharp falls in both equity and fixed-income prices.

ETF products are an easy way for investors to rebalance portfolios when asset allocations move out of alignment with their investment strategy. That’s because gaps in different asset exposures can be quickly filled through on-market purchases of ETFs that cover off any investment areas identified as needing greater exposure.

COVID-19 a litmus test

The widespread volatility on global markets spurred by COVID-19 – largely driven by the ongoing economic and financial fallout that’s still evolving – has in many ways been a test for how ETFs perform during extreme market conditions.

As already noted, the strong inflows into ETFs are indicative of their attraction to investors because they provide inbuilt diversification. But the pandemic has also tested the performance of ETFs in terms of their market liquidity.

On this level, ETF products have capably demonstrated that even during times of market duress they provided good liquidity for investors who needed to transact.

Following ETF inflows

But it is where the investor inflows have been going that’s also particularly interesting, and that underscores the increased usage of ETF products as portfolio building blocks.

In the Australian context, the biggest inflows continue to be into ETFs broadly categorised as equity products. Around a third of all equity inflows are being directed into Australian broad market index (BMI) ETFs that cover the biggest ASX companies by market capitalisation.

This top-end segment collectively accounts for around a quarter of all ETF funds under management in the domestic market.

Home bias remains a key factor in the high Australian equity inflows, although Australian-quoted products covering different segments of the global market actually account for a bigger slice of the total domestic ETF pie by value. In fact, global BMI equity ETFs on ASX represent about 27 per cent of ETF funds under management.

Thematic ETFs in favour

The inflow story in terms of Australian equity products has also been strong across ETFs covering certain sectors, such as technology, finance and resources. However, this is a much smaller space in the total market, accounting for less than $500 million in total assets.

The global equity sector segment, which includes areas such as biotech, healthcare, battery metals, cybersecurity and robotics, is much larger and holds total assets via ASX-quoted ETFs of just over $2 billion.

One theme that has been playing out over recent months in particular has been a significant increase in trades involving leveraged, inverse [provide exposure to a falling equities market] and commodity-linked ETF products, by investors chasing high returns. 

Although readily accessible on the market, these products often use more complex synthetic securities structures that may not be readily understood by many retail investors.

They can reasonably be described as higher risk when compared with “vanilla” index-tracking ETF products. It’s vital investors know what they are buying into, and these products should be used in conjunction with a strategy that utilises well-diversified ETFs as the core of the portfolio. 

After experiencing outflows during the height of the pandemic, as some investors chased the equity market rebound. Now, investors are increasingly returning to bond ETFs.

These are primarily listed bond funds holding highly rated securities – mostly Australian dollar-denominated government bonds and investment-grade securities. About $220 million flowed into Australian-dollar fixed income during the June quarter, taking total assets under management in this ETF segment to $6.6 billion at the end of June.

An unstoppable force

The appetite for ETF products on the ASX, particularly BMI funds covering the top end of the Australian market, is large. Total industry assets under management have increased 68 per cent, from $39 billion to almost $66 billion, since the end of the 2017-18 financial year. That includes the 29 per cent ($15 billion) increase in ETF assets over the financial year ended 30 June 2020.

Retail investors are the driving force in that growth, with financial advisers playing an increasing role in the take-up of ETF products as the core components of their clients’ investment portfolios.

In essence, the ETF sector offers investors low-cost access to global markets and the ability to easily add in different asset classes for diversification in a single market trade.

The spread of different ETF products in the Australian market provides investors with many opportunities to diversify across markets and sectors. Years ago, Vanguard’s late founder, John C. Bogle, advised investors: “Don’t look for the needle in the haystack. Just buy the haystack!” It’s clear from the numbers that more investors are heeding his advice through ETFs.