Wealth Management
In March, investors withdrew a total of $5.7 billion from US-listed ESG ETFs, leaving ESG funds with total assets of $81 billion according to reporting from Barron’s Lauren Foster.
A major factor in the outflows was Blackrock rebalancing its passive holdings which resulted in a $3.9 billion outflow in a single day. Other factors that accounted for this were cited as political backlash, increased regulatory scrutiny, poor performance, and market volatility.
In Europe, ESG flows are also depressed relative to 2021 but remain positive. In the US, it’s become a political issue as many conservatives are criticizing corporations for involvement in political affairs. Recently, President Biden vetoed legislation that would prevent pension funds from considering ESG factors in their investments.
There has also been some movement at the state level where conservative leaders are pursuing actions such as divesting from financial institutions that don’t invest in energy companies or companies engaging in political activity. So far, these efforst have failed but show that the tide could be turning against ESG.
Finsum: ESG funds saw major outflows in March due to a variety of factors. However, it’s clear that ESG is increasingly becoming a political issue.
In an article for Advisor Perspectives, Scott Welch and Kevin Flanagan of WisdomTree shared some strategies that can be used to generate income in the current market whether using model portfolios or ETFs.
Of course, this is a big change from the last decade when the Fed’s dovish policies meant that dividend yields on equities exceeded bond yields for the most part. This is no longer the case as the Fed is waging an aggressive hiking campaign to curb inflation even at the cost of a bump in the unemployment rate or a recession.
Thus, the Fed has already hiked rates to 5% and is forecast to hike two or three more times before the current cycle is terminated. More important, the Fed is ‘data-dependent’ and willing to change course depending on inflation and/or financial stability concerns.
This uncertainty and elevated rates mean there is a plethora of opportunities for investors to find income. For those who are comfortable with duration risk, high-yield bonds and equities are an option in addition to ETFs. For those not comfortable with duration risk, shorter-term notes and floating rate options are a good fit.
Finsum: After more than a decade of a paucity of options for income investors, the current market is offering a variety of opportunities.
About 14% of advisors are aware of and recommend direct indexing solutions to their clients which is the primary reason that its forecast to grow faster than ETFs over the next decade. In a recent article by Allen Roth of WealthLogic, he discusses the pros and cons of direct indexing and compares it to ETFs.
Direct indexing has many of the same characteristics as ETFs such as allowing exposure to broad categories and having low costs. However, it allows for greater customization that can allow for portfolios that are more tailored to a client’s needs.
Another distinct advantage of direct indexing are that it allows for tax-loss harvesting which can offset capital gains. This strategy can allow for an additional 0.2 to 1% of returns and is more beneficial in down years.
In terms of disadvantages, many of the most popular ETFs have less costs than direct indexing. For example, the most popular S&P 500 ETFs have annual expenses of 0.03%, while most direct indexing fees are in the 0.4% range.
While this won’t make a different in the near-term, it will matter in the long-term especially as tax-loss harvesting benefits erode over time. Additionally, the slight tax benefits may be outweighed by the tax complications as each trade needs to be accounted for.
Finsum: Direct indexing is expected to grow at a faster rate than ETFs over the next decade. Yet for many investors, ETF remain the better choice.
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After a decade of low rates and abundant central bank liquidity, market conditions are going to be much more challenging over the next decade. According to Jason Xavier, Head of EMEA ETF Capital Markets at Franklin Templeton, these developments mean that a major opportunity is brewing for active fixed income ETFs. He discussed this in a post for Franklin Templeton’s Beyond Bulls & Bears publication.
While most fixed income ETFs are passive, the active category is exploding in response to the need of investors to express various views. In contrast to passive strategies, active ETFs utilize fundamental analysis and have greater discretions on which instruments they can select rather than be limited by an index. Active managers have greater flexibility to respond to a change in market conditions or external catalysts unlike passive managers.
In the fixed income space, the ETF structure leads to increased price transparency and liquidity especially compared to traditional bond markets which are typically quite opaque. ETFs also give smaller investors access to fixed income opportunities which were typically only available to high net worth investors or institutions.
In sum, Xavier believes active fixed income ETFs will continue to see growth as they are likely to outperform in more volatile conditions and will lead to increased transparency and liquidity in the fixed income market.
Finsum: Franklin Templeton’s Jason Xavier sees the active fixed income ETF category continuing to rapidly grow as it offers major benefits to investors.
A recent article from Morningstar’s John Rekenthaler discussed the tax benefits of direct indexing. Direct indexing is a strategy that involves directly buying the stocks of an index rather than through a fund.
This confers several benefits such as allowing investors to gain the benefits of indexing while still being able to customize their portfolio to reflect their values and better fit their needs. Due to this, the category has exploded and gone from a niche offering solely for high net-worth investors to being offered by retail brokerages to customers for as little as $5,000.
However, the strategy is not necessarily for everyone, but it can be particularly useful for those with sizeable assets due to the potential tax benefits. This is because direct indexing results in capital losses in a separate account when stocks drop below their cost bases. The proceeds are then re-invested in stocks with similar profiles.
This strategy can be particularly useful for investors with high federal and state taxes, large amounts of money invested in direct indexing vs other investments, short-term capital gains, and dealing with a volatile market environment.
FinSum: Direct indexing comes with several benefits for clients but the most substantial one is the tax savings. However, it’s only worthwhile for a particular group of investors.
According to Daniil Shapiro of Cerulli Associates, there is a major product development opportunity for active fixed income ETFs in the coming years. A variety of factors are behind this segment’s growing popularity including the increasing acceptance of the ETF structure, growth of advisors who are comfortable with fixed income ETFs, and rising rates which lead to increased structural demand for fixed income products.
The report was compiled by Cerulli Associates based on polling of financial advisors and was covered by Kathie O’Donnel in an article on Pensions & Investment.
The major takeaway is that use of fixed income ETFs by advisors is rapidly growing with 70% reporting use in 2022, up from 63% in 2021. Most ETF issuers pointed to greater advisor acceptance of the product and institutional demand as drivers of the ETF market. Among issuers, 66% see fixed income as their primary focus which exceeded equities at 57%.
Overall, this survey reveals that there continues to be opportunity for ETF issuers in the active fixed income space, given rising demand. While there are plenty of options in passive fixed income, there are relatively less active options.
Finsum: The fixed income ETF category is rapidly expanding. Within the space, passive is saturated but plenty of opportunity remain for active managers especially given expectations of rising demand in the coming years.