ETF Focus: Stock ETFs see outflows in the first week of the new year

Will 2018 be the year that a great rotation within financial markets begin?

In the first week of the new year, investors pulled money out of U.S. equity-based exchange-traded funds, a category that saw record-shattering growth over the course of 2017. The outflows came despite ongoing strength on Wall Street; the S&P 500 SPX, +0.49%  has risen in each of 2018’s three sessions thus far, and closed at a record in each of them.

About $4.4 billion was pulled out of the category over the course of the week, according to FactSet data, while bond funds — which also saw record adoption in 2017 — had $3.7 billion in inflows.

The stock outflow comes with an asterisk, as it can be laid at the feet of the SPDR S&P 500 ETF Trust SPY, +0.50%  , which had $8.9 billion pulled over the week — enough to turn flows for the entire category negative. The SPY, as it is known for its ticker symbol, is the oldest and largest ETF on the market, and due to its extremely high liquidity — it is often one of the most actively traded securities of any type in a given session — many traders use it as a short-term hedging vehicle. As a result, flows into and out of the fund can be extremely volatile.

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The flows in the first few days of the year can’t be said to signal a rotation from stocks into bonds, particularly when adjusting for the volatility of SPY flows. However, it does come at a time when indexes are at record levels, which could lead to investors trimming their equity exposure.

Other major broad-market funds saw outflows as well, including the iShares Russell 2000 ETF IWM, -0.03% which had $1.6 billion in outflows, and the PowerShares QQQ Trust Series 1 QQQ, +0.90% where $1.08 billion was pulled. Those were the only three funds to have more than $1 billion in outflows over the first week of the new year, but all of them are higher on the week. The Russell fund has gained 1.3% while the PowerShares fund, which tracks the Nasdaq 100 NDX, +0.90%  , is up 2.9%. The S&P 500 is up 1.9% thus far in 2018.

On a sector level, investors pulled money from two industry-tracking funds in particular. The Consumer Staples Select Sector SPDR ETF XLP, +0.33%  had $670 million in outflows while $309.6 million was pulled from the Utilities Select Sector SPDR ETF XLU, -0.08% Both sectors are down thus far this year, with consumer staples off 0.4% and utilities slumping 2.5%.

Only one ETF has had at least $1 billion in inflows thus far this year, the iShares Core S&P 500 ETF IVV, +0.50%  , which just barely met that threshold.

On the bond side, the broad-based iShares Core U.S. Aggregate Bond ETF AGG, -0.13%  has been the most popular product, with nearly $700 million in inflows. The SPDR Bloomberg Barclays High Yield Bond ETF JNK, +0.08%  , which has seen $643 million in inflows, wasn’t far behind.

According to data from State Street Global Advisors, inflows for exchange-traded funds topped $464 billion in 2017, easily shattering 2016’s record of $288 billion. Equity funds had about $335 billion in inflows, by itself more than the entire industry had seen in any prior year, while bond funds had a record $126.6 billion in annual inflows.

David Santschi , chief executive officer of TrimTabs Investment Research, said that ETF flows could often act as a contrary indicator for markets. “When the bullish trade is so crowded, that’s worrisome. We’re not telling people to short the market or be out — our models are bullish to one degree or another — but things are pretty exuberant.”

There are plenty of signs of market exuberance. The latest AAII investor sentiment survey indicates that 59.8% of polled investors are bullish on the market, meaning they expect prices will be higher in six months. That’s the highest level in seven years, and significantly above the 38.5% historical average. The number of bullish investors has gone up by 7.1 percentage points in the last week alone, while the percentage of bearish investors has dropped to 15.6%, down 5.1 percentage points over the last week.

Margin debt, which is viewed as a measure of speculation, has been at elevated levels all year. According to the most recent data from NYSE, margin debt hit $580.95 billion at the end of November, its fifth record in a row, and up 3.5% from October. Records aren’t rare — according to data from Bespoke Investment Group, more than 23% of all monthly readings are records — but debt has been creeping up basically all year.

Margin debt refers to the money that investors borrow to buy stocks, and while analysts don’t necessarily see it as a warning sign in and of itself, high levels of it, especially in periods of market volatility, and can lead to sharper declines.

Optimism has gotten so high that cash balances for Charles Schwab clients reached their lowest level on record in the third quarter, according to Morgan Stanley, which wrote that retail investors “can’t stay away.” Also in the third quarter, households and nonprofits held 36.3% of their money in stocks, the second-highest rate ever. The only time this peak was topped occurred in the first quarter of 2000, during the peak of the dot-com bubble, when stock holdings reached 42% of total assets.

Morgan Stanley noted a similar trend in institutional investors, who it wrote were “loading the boat on risk,” with “long/short net and gross leverage as high as we have ever seen it.”

This could suggest that stock-based ETFs will still see heavy inflows this year, despite the action of 2018’s first few sessions. In October, Goldman Sachs estimated that U.S. flows into ETFs would hit $400 billion over 2018. Such a target would mean the U.S. ETF market grows by about 13%, excluding price changes in the underlying assets.

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