U.S. ETF Flows: Investors Are Getting Polarized

It’s been another strong first half for the U.S. ETF industry, with overall flows set to challenge (equity) or surpass (fixed income) historic records. It’s a real vote of confidence from investors given the availability of ultra-low risk, high-yielding money market funds.

The lion’s share of the flows went to the usual suspects: core portfolio building blocks; namely cheap, broad-based, market-cap weighted vanilla ETFs. But every year the lion has to fight harder to retain dominance.

In the first half of 2024 that fight got interesting as investor attention turned to spot bitcoin and active management.

Two ETF landscapes: core vanilla and everything else

Since 2018, when the courts invalidated the fiduciary rule, ETF flows have bifurcated. Some have gone to core building blocks, while others have headed to complex or tactical positions. Core, complex, and tactical ETF groups have all gotten cheaper over the years because of intense competition and client demand. However, as demand for non-core ETFs has grown, overall industry fee compression among the three slowed because the non-core products command higher price points.

How did we get here?

In 2015, President Barack Obama introduced the fiduciary rule thusly: "Today, I'm calling on the Department of Labor to update the rules and requirements that retirement advisors put the best interests of their clients above their own financial interests. It's a very simple principle: You want to give financial advice, you've got to put your client's interests first.” The DOL’s initial Fiduciary Rule was issued and then delayed in 2016 and vacated in 2018.

In 2016 and 2017, when clients’ best interest was front and center, flows into the simplest, cheapest ETFs with plain vanilla investment strategies peaked as investors questioned the higher costs and potentially divergent returns of the more complex products. After the strong form of the Fiduciary Rule was struck down in 2018, vanilla ETF flows receded. So-called “smart beta” (strategic), active, and idiosyncratic strategies such as ESG or single-exchange sourcing have since captured market share.

The following two charts show annual equity and fixed income ETF flows by strategy group. A red outline marks the old Fiduciary Rule years.

Since 2018, the SEC’s and the DOL’s actions have dramatically altered the ETF landscape. SEC permissions including the ETF rule, mutual fund-to-ETF conversions, and approvals of spot crypto ETFs have opened the door for ETF issuers to launch a panoply of products. The DOL has left somewhat of a regulatory vacuum as it slowly penned a new fiduciary rule, which may be blocked by the Fifth Circuit before its September implementation date. In the interim, advisors have felt less constrained. The result: an increasingly heterogeneous yet remarkably competitive U.S. ETF industry.

This year, the diversity showed up at the asset class level, with a burst of interest in currency ETFs, specifically spot Bitcoin.

Traditionally, ETF investors showed little interest in asset classes beyond stocks and bonds. Gold would sometimes capture a few percent of the flows, and geared ETFs had a moment in 2022, but those breakouts were rare. Then, in January 2024, came spot Bitcoin ETFs.

At the end of 2023, currency comprised just 0.04% of the U.S. ETF landscape. Yet currency ETFs captured 3.6% of all first-half 2024 flows as $14.7 billion rushed into spot Bitcoin ETFs.

The chart below shows the asset class breakdown of flows to U.S. ETFs since 2016. Equity (blue) and fixed income (green) stand out, topped by a smattering of commodities (yellow) and geared ETFs (gray). The 2024 spot Bitcoin allocation pops out in purple, and 3.6% of semi-annual flows is notable.

The pivot to active management

FactSet Funds defines four general types of investment strategies.

• Plain vanilla aims to replicate a swath of the market, broad or narrow.

• Strategic, sometimes tagged as “smart beta” uses academically grounded research elements to select and/or weight securities. Strategics include value, growth, dividends, fundamental, and factor investing.

• Idiosyncratic ETFs share the complexity of strategics but lack the academic rigor. They can be simple equal weighting, single-exchange selection, or ESG, which aims to correct for economic externalities.

• And then there’s active, in which humans select and weight the portfolio securities.

As shown in the following two charts featuring the dollar levels of flows into equity and bond ETFs broken down by investment strategy, investors have increasingly favored active management throughout the past several years. Look for the recent pop in the yellow bars, which show flows to active.

Don’t forget we’re just at midyear 2024. Every other year shown covers the full 12-month span.

Flows to the plain vanilla equity ETFs are on track to top all previous years except 2021; flows to active equity ETFs are on pace to shatter records. Notably, these flow numbers do not include mutual fund conversions. Many of the active ETF clients may be new to the ETF industry, bringing along manager preferences as they opt for the efficiency and cost-effectiveness of the ETF wrapper.

The opting into active is even more profound in fixed income, per the chart below. Actively managed fixed income flows have already broken all annual records as of June.

In the following two charts, we can see the effects of flows on equity and fixed income ETF asset levels over time. Again, those yellow bars—indicators of active management—become more prominent.

Equity ETFs in three of the four strategy groups—vanilla, strategic, and idiosyncratic—grew between 12% and 15% year-to-date, mostly because of strong equity returns. Active equity AUM grew 30% because of strong flows on top of a relatively small base as well as market returns.

AUM growth year-to-date in active bond ETFs has popped significantly, up 25%. Vanilla AUM grew 4%, as befits a more mature portion of the industry.

Active management is clearly on a roll in both equity and fixed income ETFs, claiming increased market share. Notably, it may not be a closed system in which active’s gain results in a loss for the other strategy groups. Rather, it’s a classic grow-the-pie scenario.

One way to gauge this is to look at the growth of the 50 core vanilla ETFs, which cover broad-based, cap-weighted US large caps/total market and global/developed, and emerging market equities and investment grade aggregate bond ETFs. They have garnered over $100 billion in inflows through June this year, putting them on track for their third-highest haul ever.

The core, “cheap beta” ETFs continue to attract new investment.

The trajectory of expense ratios

If the old fiduciary rule was in effect today, we would expect these efficient, simple, cheap ETFs to dominate the flows charts. Instead, we have a situation where some investors are attracted (or directed via their advisors) to higher-cost asset classes or investment strategies. While cost competition is lively within all ETF niches, heterogeneous ETF preferences are slowing overall fee compression.

Perhaps that’s an understatement. The top-line number, the asset-weighted ETF expense ratio for all U.S.-domiciled ETFs, actually rose 0.002% in the first half of 2024, kicking costs back up to 2022 levels. A reversal? That’s huge news.

Or is it? The rise is attributable to one ETF: Grayscale Bitcoin Trust (GBTC-US). GBTC, which converted into an ETF in January, charges 1.5% and has a huge asset base, so it rocketed up to become the third-highest revenue generator of all US ETFs, behind only SPY and QQQ.

But GBTC is an anomaly and is fast disappearing. It used to be a private trust, charging 2.00%, which Grayscale got away with because accessing bitcoin in a security was tough. But now that Bitcoin ETFs are available, GBTC is wilting under the competition. Despite dropping its expense ratio by 0.50%. GBTC lost $18.3 billion—more than half its pre-conversion assets—in the first half of 2024.

Excluding GBTC, US ETF expense ratios fell a wee bit, by three hundredths of a basis point, as shown in the chart below.

Perhaps it’s fair to say that at a headline level ETF expense ratios have held steady over the first half of 2024.

GBTC’s odd history explains the overall uptick in ETF fees as of June 2024, but it doesn’t explain the contrast between equity and fixed income fees. Equity ETFs’ asset-weighted price tag dropped by two tenths of a basis point; bond ETF fees rose by the same amount.

Fee compression in equity is easy to explain: Investors favored lower-cost funds over higher ones within each strategy group and as a whole. Equity ETFs that gained market share cost just 14 basis points; losers cost 18. The relationship also held in fixed income, where winners cost 13 basis points, and losers cost 14. But the wild success of active fixed income ETFs in the first half of 2024 drove overall bond ETF expense ratios up. Active remains pricier at 36 bps than the 10 bps vanilla funds it displaced.

The mechanism behind the fee compression becomes clearer when we look within each major strategy group in both equity and fixed income.

All equity strategy group’s fees fell, mostly by two or three tenths of a basis point. Idiosyncratic ETFs—those focused on non-market factors such as listing exchange or ESG, or equal weighting—had a larger price drop on an asset-weighted basis. For example, Invesco QQQ (QQQ-US) cost 0.20%, and its lower-cost clone Invesco NASDAQ 100 ETF (QQQM-US) cost 0.15%. Both dominated both flows and AUM.

Notably, the rate of fee compression in active management slowed just two tenths of a basis point year to date compared to almost two basis points in 2023. That’s in part because the most popular active equity ETF, JPMorgan Equity Premium Income ETF (JEPI-US), carries a fee of 35 basis points—just above the asset-weighted fee of 36.2 basis points for actively managed equity ETFs.

Investor preference for low-cost active management is clear. Active equity ETFs that gained market share within their market segment cost, on average, 34 basis points. In contrast, those that lost market share cost 52 basis points on average. The cost gap between gainers and losers, parsed by investment strategy group, appears in the chart below. The blue bars are for successful ETFs; those that gained market share or have no competition within their specific market segment. The gray bars are for unsuccessful ETFs; those that lost market share or closed.

Equity ETF investors favored cheaper funds over pricier ones in all strategy groups except Strategic.

It is hardly surprising that ETFs facing no competition charge much higher prices than those in competitive segments. But it’s telling that the funds that folded cost far more than those that attracted new investment. Purveyors of actively managed equity ETFs take note: If you want your fund to grow, price it at 34 basis points or lower.

The 2024 fee compression story got a bit more complicated in fixed income. Cost dropped for vanilla, strategic, and active bond ETFs, but rose for the idiosyncratic ones. Active fees fell hardest, dropping over a full basis point, largely because $5 billion flowed to Janus Henderson AAA CLO ETF (JAAA-US), which dropped its fees from 22 to 21 bps, placing it well below the 36 bps price tag for the average active bond ETF.

While 36 basis points may be cheap among actively managed bond mutual funds, it’s quite costly in comparison to average fees for plain vanilla bond funds, which dropped to 10.2 basis points as of June 30. Given that actives captured 2% market share among fixed income ETFs, it follows that overall bond ETF costs ticked up a smidge, by two-tenths of a basis point.

The SEC, DOL, and Courts have a profound impact

That cost uptick—driven by flows to actively managed ETFs and the unprecedented interest in currency ETFs because of the SEC’s approval of spot bitcoin ETFs—would not have fit with the fiduciary rule. In those days, advisors expected to justify precisely why their fund selection process served the best interest of the client. As a result, they stuck to broad-based, cap-weighted vanilla ETFs.

In today’s more permissive atmosphere, those core portfolio ETFs are still vibrant, but many investors have turned their attention to shinier and sometimes more speculative investments. Who, exactly, is watching out for their best interests?

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