Buying ETFs doesn’t mean you have to be a passive investor

A passive expert at Morningstar points out why critics of passive investing are wrong to say that ETFs are not the right vehicle to be in when markets turn bearish.

These are not easy times for investors. A mix of rising inflation, rising interest rates and a slowing economy makes for rather treacherous waters. Broad equity and bond markets are experiencing falls.

Given this backdrop, one may be forgiven for thinking that investors could be extremely wary of putting too much money to work. But if inflows into the exchange-traded fund (ETF) market are anything to go by, this is far from being the case.

In the first four months of 2022, the European ETF market has netted €58 billion (£49 billion) of inflows. While this is an 11% decrease compared to the same period in 2021, it hardly speaks of a market paralysed by fear, not least considering that the sustained capital losses so far this year mean that total assets under management in European ETFs are still lower than at the close of last year.  

This investor behaviour is not surprising when you think about it. After all, what use is it to hold cash when inflation is running close to double-digits? If one takes a long-term view, then this could be a good time to bag a few bargains. The rewards may take time to arrive, and you may have to bear some temporary pain, but that's the nature of investing, isn't it?

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So, where have European investors put their money in ETFs? Mostly in equity markets, but increasingly so in fixed income. 

Inflows into equity ETFs in the first four months of 2022 amounted to €39.1 billion, or just over two-thirds of all money invested in ETFs over the period. And the bulk has gone into broad market exposures such as Global Large-Cap or US Large-Cap (€8.8 billion and €8.7 billion, respectively). ETFs tracking the likes of the MSCI World or the S&P 500 remain a favourite staple, despite the fact that both indexes have shed around 13% so far over the period.

Investors have also directed money to ETFs offering exposure to value stocks and, unsurprisingly, energy stocks. By contrast, growth stocks have fallen out of favour. Here, we see an example of how the ETF wrapper allows investors to quickly take positions in areas where, despite the general outpouring, the sun still shines – in fact, in the energy sector it has been blindingly bright.

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Critics of passive investing would tell you that ETFs and index funds are not the right vehicle to be in when markets turn bearish. However, this simplistic interpretation purposely ignores the fact that the ETF market has developed to offer all kinds of exposures, broad and narrow. This affords great flexibility to express both long-term, as well as short-term, tactical views, allowing us to choose almost with surgical accuracy which slice of the market we want to be in at any given time. As I like to say, using passive funds doesn't mean you have to be a passive investor.

Bond ETFs have gathered €9.3 billion of inflows in the first four months of 2022, but almost half that money arrived in April. After some aborted attempts in recent years, central banks have now put themselves on serious monetary policy tightening mode. Of course, those with long memories will say that these remain highly unusual times and that for all the noise about hikes, interest rates continue to be at historically low levels. They are right, but what counts here is the direction of travel.

To say that central banks are in a bit of a predicament is a massive understatement. They have little option to display their armoury to fight the extremely insidious effects of high inflation, and yet by acting, they know they can tip the economy into recession. The Bank of England has been rather candid in their assessment, calling a spade a spade and warning us all of the dangers ahead.

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This market backdrop has favoured investment in shorter-duration bond strategies – again, an example of how ETFs slice and dice a market – which are less sensitive to capital losses than long maturities when interest rates are on the rise.

However, the choice for shorter maturities has been stronger in UK and European bond markets than in the US. In the latter case, we have seen investors starting to place money on longer maturities, too. This likely reflects how investors perceive how different central banks are responding to the challenges, with the US Federal Reserve ahead of the curve – that is, closer to reaching a peak – relative to its European counterparts.  

Jose Garcia-Zarate is associate director passive fund research at Morningstar.