The first few months of 2022 have made it clear that exchange-traded funds are well-positioned for another record year. In January, trading volume hit a record high as dollar turnover exceeded $478 billion in a single day, beating out the previous record of $404 billion from February 2020. With fixed-income ETFs undergoing rapid growth in size and popularity, the buzz around thematic funds and crypto, and talk of regulatory scrutiny of ESG funds, the ETF landscape continues to evolve and expand opportunities for investors.
In a recent virtual panel moderated by Athanasios Psarofagis, ETF Analyst at Bloomberg Intelligence, experts from Jane Street, Fidelity and State Street had an in-depth discussion on ETF trends and the opportunities and challenges investors can expect as the market continues to grow and become more sophisticated. Read on for more key takeaways from the panel.
A stress test from Russia
The Russian invasion of Ukraine and the resulting humanitarian crisis have caused global disruptions that affect people’s lives worldwide. “It’s really key to remind folks that there are people’s lives on the other side of this. I think that’s why you’ve seen such a strong sort of reaction both from the private sector, as well as governments in the West, when it comes to sanctions and a lot of voluntary divestment and distancing from Russia in general,” said Ugo Egbunike, Sales and Trading at Jane Street.
Egbunike noted that the “unprecedented” situation resulted in an uptick in activity on the first day of the invasion, followed by Moscow announcing capital markets would be shut down the next day. With ETFs then trading down, Egbunike said, they were both a source of price discovery and also “a way for market participants to be able to access and express their opinions on Russia.” While there are some parallels for ETFs to 2011’s Arab Spring, there was more optimism with Egypt that investors would regain access to capital markets, whereas “in the case of Russia, there really is no real sense of when the sanctions will allow investors to access those capital markets, and more importantly, when investors will feel comfortable allocating capital there.”
“Historically, investors have turned to ETFs in times of turmoil, both as sources of liquidity and as vehicles of price discovery,” said Kimberly Russell, a Market Structure Specialist at State Street Global Advisors. She said this situation has also highlighted the limitations of ETFs in some ways, as well. “ETFs aren’t immune to everything,” she said, and with the combination of war, sanctions, market restrictions and closures, and investors distancing themselves from Russia, “valuations basically go down to near zero.”
While trading of some Russia ETFs was halted, Russell said she thinks “ETFs still provided one of the best ways to weather the crisis” and pointed out that funds with Russia exposure as part of a broader strategy, like index ETFs, have continued to trade and have “behaved as would be expected in terms of valuations, spreads, premiums and discounts.”
With regards to product development, Russell said it’s hard to say what will happen next. While these types of securities could be permanently impaired, securities might resume normal trading and be brought back into the mainline indexes. However, she added, that could take a while because index providers would want to review and consult before returning to funds with Russian assets. She summarized that this experience “serves as an example of the risks of investing in an autocratic state.”
Rise of fixed-income ETFs
Matthew Laird, Head of Institutional Cash Equity Trading at Fidelity Investments, said while they’re seeing more orders for equity ETFs relative to fixed-income ETFs, most of the largest ETF orders coming across the desk are for fixed-income funds. He said the majority of those orders are highly liquid aggregate corporate products and broad-based index products. Inflation-protected ETFs, he said, are unsurprisingly also on the rise as a percentage of total orders, but they continue to lag municipals and government-focused ETFs.
“A lot of the larger inflows and outflows we see appear to be used for tactical allocations, but more and more frequently, we’re actually seeing a lot of flows into short-term cash ETFs or short-term dated treasuries and ETFs and things like that during periods of uncertainty,” Laird said. “So whereas I think 10 years ago, maybe, you’ve seen people during times of stress going into money market funds or cash equivalents,” he said, “a lot of times we’re seeing traders using the cash ETFs as a kind of a safe-haven during periods of extreme volatility and parking things there.”
“I think really the pandemic has accelerated fixed-income ETF usage,” Russell added. “It was already a trend that was growing,” but at the start of the pandemic, when liquidity and underlying bond markets dried up, investors began turning from difficult-to-trade asset classes to ETFs for the ease of execution.
Before the onset of the pandemic and the volatility that soon followed, there was a question of how well ETFs would hold up, but what resulted was fixed-income ETFs providing a solid solution for investors. Russell said the conversation has shifted, and ETFs are forcing conversations about the evolution of the underlying fixed-income market structure. There are calls to improve transparency and questions over whether better quality data is needed.
Trends to watch
2021 saw a record number of new ETFs hitting the market, breaking the previous year’s record, with active and thematic funds making up the biggest portion of new products. Targeting trends in sectors like electric vehicles, artificial intelligence, biotechnology and cybersecurity rather than more traditional or more broad industry segments, these funds have become popular with a new generation of retail investors.
Laird said he sees a wide variety of thematic funds coming across trading desks, and some rank among the most frequently traded. He also noted that the average trade size is smaller than what is typically seen for more established, broad-based passive funds. While there’s a lot of chatter and interest amongst retail investors, there’s yet to be widespread adoption by institutional players for most of the newly created thematic ETFs.
Environmental, social and governance funds make up a sizable portion of the newly launched ETFs as investors look for more socially conscious options. With demand for these types of products expected to continue, they’ve also caught the attention of regulators. In Europe, the Sustainable Finance Disclosure Regulation (SFDR) went into effect last year, aiming to give investors more clarity about how sustainability risks are being evaluated in the disclosures provided by asset managers and investment advisors.
The SFDR calls for products to be classified into categories so that investors can more easily understand and compare ESG, making it harder for asset managers to “greenwash” their products by branding them as sustainable without being transparent about how sustainability is achieved. In the U.S., the Securities and Exchange Commission is also taking an interest in the disclosures issuers put out and will likely be examining those provided by registered investment advisors soon.
Laird said actively managed ETFs, like thematic ETFs, are seeing some trading, but the average order size is smaller than more established broad-based passive funds. While the share of active ETFs only makes up a small portion of the total ETFs traded, it’s growing, according to Russell, who said she expects growth to continue in the next few years. For the first time last year, more active ETFs were launched than passive ones. With the increased demand for fixed-income ETFs, it’s likely that funds overseen by seasoned bond managers will only increase in popularity in a crowded but growing ETF market that continues to adapt to investor needs.