The ETF industry has come a long way from its roots as an innovative yet overlooked alternative to mutual funds. What used to be unique traits that made them novel products — tax efficiency, portfolio transparency, low cost, and so on — are now par for the course. And as the ETF space becomes more crowded, terminations and mergers of unpopular or poor-performing funds should occur more frequently.
Those who actively watch their portfolios may have a habit of monitoring capital inflows into and outflows from the ETFs they’re invested in, just so they’re not caught off-guard when the worst happens. So when a fund they hold loses a seventh of its assets managed in one day, they may understandably consider heading for the hills.
But such massive ebbs aren’t always causes for alarm. As reported in The Wall Street Journal, the US-listed iShares Edge MSCI USA Quality Factor ETF, which held some US$10.5 billion in assets, shed US$1.5 billion on a single day, representing the largest outflow in its six-year life.
The fund invests in companies with stable earnings and lower debt levels, so a simple explanation for the historic retreat would be a sudden attack of investor pessimism on such companies. But the Journal noted that “the outflows were just one leg of a $3 billion two-way trade that began days earlier, and had little to do with market sentiment.”
The event illustrates what happens when popular benchmarks from the world’s largest providers undergo their periodic rebalancing, which in turn triggers titanic money shifts that reflect portfolio managers’ efforts to keep their holdings in line with the updated indexes.
While ETFs aren’t necessarily the largest index investors, they’re the most transparent. The majority of ETFs disclose their portfolio holdings and investment flows daily, as opposed to mutual funds and large institutional investors that play close to the vest and use the benchmarks as performance yardsticks.
The rebalancing exercise for ETFs in particular can set off reciprocal in-then-out trades that, when plotted on a graph, can resemble the peaks and valleys on an electrocardiogram. Such “heartbeat” flows, first described by Elisabeth Kashner in 2017, are most often observed among funds that track specialized indexes where companies are frequently added or dropped from the portfolio.
“This is more of a phenomenon not just for indexing, but for complex indexing where there’s a high turnover,” Kashner, who is currently the director of ETF research at FactSet, told the Journal.
The iShares quality ETF is just one of numerous funds that depend on smart MSCI indexes, which use specific factors to inform their portfolio holdings. Other funds in the series experienced similar outsized trades, which are also known as “kickers” or “friendlies”; they often arise from arrangements between portfolio managers and the largest market makers that would have little issue with tying up billions of dollars over several days.
“By swapping out large blocks of stocks, the ETFs are also able to shed shares that might otherwise trigger a taxable gain,” the Journal said. “Big money shifts don’t necessarily mean big price moves, especially in large U.S. stocks. The changes are typically understood well in advance, and portfolio managers have plenty of time to prepare.”
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