June 8, 2022, call highlights
ETF flows rebound in May1
- After experiencing their first month of outflows since 2018 in April, exchange-traded funds (ETFs) took in more than $66 billion in May.
- Inflows were largest among U.S. bond ETFs, which added $35 billion in May. U.S. Treasury ETFs accounted for more than half the monthly bond inflows, taking in $18 billion. Municipal bond ETFs set a monthly inflow record with $6.5 billion in new money.
- Flows into large-cap equity ETFs rebounded from April and significantly outpaced other stock categories.
- Sector stock ETFs shed more than $1 billion, primarily due to outflows in the financial, energy, technology, industrial and real estate categories. ESG (environment, social and governance) ETFs experienced monthly outflows for the first time in several years.
This month’s focus: An index is an index, right?
- The growth of passive investing has been huge. According to the Investment Company Institute, assets in U.S. passively managed funds recently surpassed actively managed funds for the first time.
- Index funds offer important benefits to investors, including diversification, transparency, tax-efficiency, low turnover and low costs.
- However, passive funds with similar names and similar strategies and benchmarks can deliver dramatically different results.
Returns can vary widely
- In 2021, Morningstar’s large-cap growth equity category included 74 ETFs with a full calendar year return. Annual returns in 2021 ranged from a maximum of 56.96% to a low of -9.30%, for a range of more than 66 percentage points.
- Among the 103 ETFs in Morningstar’s large-cap value category with a full calendar year return, 2021 returns ranged from 45.30% to 12.48%. The difference between the top performer and the bottom performer was nearly 33 percentage points.
- These results highlight the different approaches ETFs may take in pursuing large-cap growth and large-cap value strategies. Some track broad market indices, while others may use custom indices designed to identify companies exhibiting specific growth or value characteristics.
Keep style differences in mind
- While many ETFs in the growth and value equity categories have similar names, they may have different views on what constitutes “growth” and “value.”
- Among value ETFs, strategies may vary, with portfolios focusing on low-priced companies, deep-value companies, dividend payers, dividend-growth companies, or a combination of factors.
- Among growth ETFs, it’s important to understand what defines “growth.” Is it momentum? And if so, how does the fund define momentum and its corresponding index? Other strategies/indices may focus on companies with high historical growth, accelerating growth or growth at a reasonable price.
Know the risks of market-cap strategies
- Passive funds that employ market-capitalization-weighted strategies may face concentration risk. Companies with the largest market caps typically comprise a significant portion of the index.
- For example, in the Russell 1000 Growth Index, the top five holdings comprised nearly 40% of the index at the end of April. The index’s top 10 holdings represented nearly half of the index.2
- Furthermore, large technology companies have constituted a big portion of the Russell 1000 Growth Index. At the end of April, the “FAANG” stocks comprised nearly 28% of the index, while nearly 39% of the index was invested in the “FAMGA” group.3
- Large-cap growth portfolios that use measures other than size to identify growth—and track different indices—may not have this concentration.
Alternative indices can focus on fundamentals
- Market-cap indices and portfolios don’t incorporate fundamentals into the stock selection process. Size is the primary measure, so they own stocks regardless of the underlying companies’ financial strength or health.
- Conversely, funds that track alternative indices typically incorporate screens to identify specific characteristics.
- For example, quality may be a screen in growth and value portfolios. ETF providers can develop custom indices focusing on attributes they believe define quality.
Understanding rebalancing schedules
- Market indices typically have fixed rebalancing schedules.
- For example, funds tracking the Russell indices rebalance once a year. Russell announces the changes in May and rebalances in June. In that 30-day window, stocks affected by the rebalance are subject to various trading anomalies, which ultimately may influence performance.
- Alternatively, ETFs tracking custom indices can set their rebalancing schedules to seek optimal turnover. Notably, thanks to the in-kind creation/redemption mechanism underlying ETFs, more frequent turnover has not historically led to meaningfully higher capital gains distributions.
1 All data cited in this summary per Bloomberg and Morningstar Direct
2 Source: Bloomberg as of April 30, 2022.
3 Source: Bloomberg as of April 30, 2022. FAANG represents Facebook (now Meta), Amazon, Apple, Netflix and Google (now Alphabet). FAMGA includes Facebook (now Meta), Amazon, Microsoft, Google (now Alphabet) and Apple.