Part 3: The aftermath of 2023 – where to next?

Today we explore ETFs.

Kathleen Gallagher, SPDR Exchange Traded Funds managing director at State Street Global Advisors

How has the ETF industry coped with unfolding events in 2023 compared to the previous year?

The Australian market has not been immune to the variety of surprises and shocks experienced by international markets in 2023. Volatility persisted in 2023 because of stubborn inflation, higher-for-longer central bank rates, and several geopolitical concerns. As a result, there was a flight to safety, and flows in the ETF industry reflected this with cash, fixed income and perceived defensive asset classes receiving most of the inflows.

Despite this, globally, ETFs have seen net inflows of US$803bn for the year to date as of 31 November. This is a marginal increase versus last year in terms of flows, but with positive market movement, the overall AuM in ETFs has increased 19 per cent to almost US$11 trillion. Where there was a difference in 2023, versus 2022 was that fixed income saw increased inflows of 15 per cent YoY (as end of 31 November) and Active ETFs (primarily fixed income) also captured an increase of 50 per cent inflows YoY, albeit from a low base. With rates higher and bonds yielding more, Precious ETFs continued to be in outflow for the second consecutive year (source ETFGI.com).

In Australia, ETF AuM is up 5 per cent to US$92 billion, with inflows YTD of US 8 billion which is down YoY by 20 per cent. Again, fixed income and near cash ETFs have accounted for more of the flow this year at 46 versus 13 per cent in 2023. As risk assets have been under pressure, investors have looked for capital protection.

What specific challenges have ETFs faced this year, and how have they responded to key stress tests?

Investors’ fears were routinely stoked throughout 2023, with rising rates, US bank failures, lack of a substantial recovery from China post-COVID, the ongoing Russia-Ukraine conflict, and the risk that the Israel-Hamas war could entangle additional countries in the wider Middle East.

Our research has found that when the market is volatile it is important for investors to have more liquid investments. Regardless of whether they have ETFs in their portfolio, globally, more than half of investors agree ETFs offer more liquidity to respond rapidly to market changes (52 per cent) and can mitigate risk better in volatile markets compared to other investments (51 per cent).

Throughout 2023, the ETF structure continued to show its resilience, as demonstrated by continued inflows. ETFs offer a simpler way for advisors to execute investment strategies whether it be seeking returns or managing risks in portfolios.

In Australia, financial advisers are increasingly embracing ETFs as fundamental "building blocks" for implementing asset allocation decisions for their clients. They use them strategically as a core exposure or tactically when they see an opportunity in the market where they can add further returns for their client. The latest Rainmaker information showed that ETFs continued to see inflows while nit trusts continued to see outflows (source Rainmaker “Wealth management, a year in review”). ETFs have significantly changed the way that Australian financial advisers can invest by providing them with efficient and cost-effective access to numerous asset classes and investment strategies.

In light of recent events, what strategic shifts or innovations are ETFs adopting for continued growth and resilience?

The innovation continues to focus on bringing in asset classes, sub asset classes, and investment strategies that meet investors' needs, and allow them to navigate markets to build cost-effective, resilient portfolios.

This year we have seen continued flows to, and launches in, near cash and fixed income products which is reflective of the overweight the industry has been in equity products. In 2022, Fixed ETF only accounted for 17 per cent of flows, this year it accounts for 44 per cent of flows.

Looking beyond core passive, smart beta investing continues to be popular with investors looking for the middle ground of passive versus active investing. Smart beta is an investment approach that involves targeting specific drivers of a return across asset classes. When we talk about these ‘factors’ in a smart beta context we are generally talking about style factors such as value, size, minimum volatility, dividend, quality, and momentum. The theory is that investing in factors can provide a more targeted approach to portfolio investing thus enhancing overall portfolio diversification.

ETF use cases in the advisory market continue to evolve beyond just asset allocation and diversification planning. Several wealth management firms use ETFs to package their investment beliefs into outcome-oriented products for their clients. ETFs have also been used to create model portfolios that give advisors the ability to outsource the investment component so that they can focus more attention on client outcomes.

However, overall ETFs’ continued popularity lies in their versatility. In addition to allowing investors to broaden their asset allocation, ETFs can be used to meet strategic goals, allocate funds tactically, access hard-to-reach markets, and help with ongoing portfolio management.

What trends and opportunities do you foresee for ETFs moving forward into 2024?

We see the potential for innovation in multiple areas of the market but the main area will be fixed income. Globally, fixed income ETFs only account for 17 per cent of AuM. But in a low-return environment and with rising bond yields, investors are seeking to put more in the fixed income element of their portfolios. Historically, ETF use has been dominated by equities, however over the past five years fixed income has rapidly evolved and grown globally. And, the benefits of fixed income ETFs (scalability and diversification relative to individual holdings, liquidity, lower fees and transparency) are becoming more understood.

We expect further launches in active ETFs. This was heralded by some well-known active manager entrants this year in the Australian ETF market. Active ETF launches are also reflective of the growing confidence advisors have in the structure itself.

There will be continued development in smart beta, as most strategies currently available in the market seek good levels of exposure to all smart beta factors simultaneously, but do not necessarily take into account changing market conditions. The next generation of smart beta multi-factor strategies will likely focus on targeting different factors more dynamically, adapting according to prevailing market conditions. Factor timing would be one example of this.

We also see potential for innovations in multi-asset, multi-factor strategies. For example, targeting different factors in commodities, equities, fixed income and currency. Multi-asset class or solution-based ETFs give advisers the ability to outsource the investment component to improve the overall efficiency of their practice and thus focus on client outcomes.