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Investors climbing on the equity ETF bandwagon are spreading their exposure across different equity styles and looking at cheaper valuations outside U.S. share markets.Klaus Schneider/iStockPhoto / Getty Images

Piles of cash amassed during lockdowns are flowing into financial markets as retail investors rush to put money into record-setting equity markets.

During the first four months of 2021, there were inflows of US$269-billion into U.S.-listed equity exchange-traded funds (ETFs). That exceeded last year’s entire total of US$249-billion, according to CFRA Research, a New York-based independent research firm.

The U.S. ecosystem of ETFs across equities, bonds, commodities excluding gold, and other areas has already attracted US$332-billion of net flows in 2021, a pace that puts the industry on track to match or exceed last year’s record US$503-billion of inflows.

Investor enthusiasm reflects a couple of forces. Low-cost ETFs passed a structural test during the market turmoil of March, 2020, further boosting their appeal for investors who prefer them over actively managed mutual funds. And investors have been drawn in by a story of a recovery in economic growth and corporate earnings after a pandemic-hit 2020.

“The significant rise in the use of ETFs comes from investors being more confident with the product and the inflows are aligned with an economy moving out of a recovery phase to one of expansion,” says Matthew Bartolini, head of Americas Research at State Street Global Advisors in Boston.

Clearly, this year looks very promising for economies and the bottom lines of companies, but an important question for those investors buying into equities is how much this has been priced in.

The share market has discounted a strong recovery in corporate earnings this year, and it means the answer to the question will rest with how sustainable the expansion looks in 2022, and whether inflation stays relatively constrained.

In the near term, strong equity inflows signal caution for long-time market watchers as they have pushed valuations higher.

The S&P 500 is trading at a 12-month price-to-earnings ratio of 22 times, above its average of 17.9 for the past five years, according to FactSet Research Systems Inc.

Elevated valuations were highlighted by the U.S. Federal Reserve Board’s latest Financial Stability Report last week, which noted that some assets “may be vulnerable to significant declines should risk appetite fall.”

After a relentless rally in share markets since late 2020, when vaccines were first announced, the prospect of a sizeable pullback has risen with selling potentially exacerbated by investors quickly exiting via ETFs.

Typically, a 5 per cent equity sell-off occurs three times a year, but that has not been seen in the past six months. The absence of a 10 per cent correction in the past 14 months jars with a pattern of at least one occurrence per year, according to Bank of America. A backdrop of very supportive fiscal and monetary stimulus has probably played a part in stemming selling pressure to date.

But in the rush for broad market exposure and for ETFs that track emerging markets, international shares and so-called value stocks, there are signs that investors are aware of the risks.

“Investors are seeking diversification and not being so exposed to extreme valuations, which is healthy,” says James Paulsen, chief investment strategist at The Leuthold Group LLC in Minneapolis.

He says this had been shown in the equity market’s “rotational leadership” during the past year of its bull run. The latest example played out last month when value and cyclical shares retreated after their strong run from last November.

Further evidence of a broadening investment focus is shown in the breadth of inflows. Two-thirds of ETFs have recorded net inflows so far this year, according to State Street Global Advisors. This represents the highest rate for the first four months of a calendar year since 2014, when the ETF industry was much smaller, according to Mr. Bartolini.

This might partly reflect a bigger shift underway in asset allocation with a rush of money into equities at the relative expense of bonds.

Demand for reliable sources of income via the fixed rates paid on bonds has attracted the lion’s share of investor flows in past years, led by retirees and older workers intent on preserving their capital.

After a negative first quarter for high-quality bond returns, there was a rebound for the sector last month. But given a world of very low bond market interest rates, there is limited scope for further capital appreciation. Bond prices also are vulnerable to faster economic growth and rising inflation pressure.

Investors climbing on the equity ETF bandwagon are realistic to some degree – money needs to find a home and many areas of fixed income lack appeal. So, they are spreading their exposure across different equity styles and are looking at cheaper valuations outside U.S. share markets. But a pronounced shift in flows to equities at lofty levels and away from bonds depends on a profound change in the macro narrative.

Namely, that the pace of the economic expansion into 2022 proves a lot more robust and enduring than the moderate growth and disinflationary winds that defined the decade after the global financial crisis.

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