Asset flows for the ETF industry gained steam during the second quarter of 2014, as net inflows totaled $61.8 billion, bringing the total for the first half of 2014 to $74.3 billion.1 Net inflows for the first half of 2014 were dominated by international equity ETFs (+$24.5 billion), sector ETFs (+$22.1 billion), and taxable bond ETFs (+$22.1 billion). Conversely, net asset flows remained negative for commodity ETFs during the first half of 2014 (-$459 million). In this newsletter, we’ll take a closer look at each of these categories, highlighting various opportunities among the First Trust family of ETFs.
International Equity ETFs
Net asset flows for international equity ETFs accelerated dramatically from the first quarter (+$1.5 billion) to the second quarter (+$22.9 billion). Within this group, European equity ETFs attracted the strongest net inflows during both quarters, totaling $13.5 billion for the first half of 2014. This continued a trend that emerged in 2013 when net inflows for European equity ETFs totaled $21.9 billion.
Despite significant imbalances in the distribution of Europe’s economic recovery among constituent nations, and mounting geopolitical concerns, many ETF investors remain bullish on European stocks. This positive outlook is bolstered by the European Central Bank’s commitment to keep interest rates low for an “extended period of time”2, the region’s return to positive economic growth (Chart 1), a declining unemployment rate (Chart 2), and steadily improving consumer confidence (Chart 3).
For ETF investors seeking exposure to Europe:
- The First Trust Europe AlphaDEX Fund (FEP) provides broad exposure to European equities. This ETF tracks an index which employs the AlphaDEX methodology to select and weight a portfolio of 200 stocks from the S&P Europe BMI universe.
- The First Trust STOXX European Select Dividend Index Fund (FDD) provides exposure to a portfolio of 30 high dividend-yielding stocks selected from a universe encompassing 18 European countries
As a category, sector ETFs also received strong net inflows during the first half of 2014, exceeding $11 billion in both quarters. Among this group, energy-related ETFs attracted the strongest net inflows, as traditional equity energy ETFs received $5.4 billion and energy Master Limited Partnership (MLP) ETFs received $2.3 billion. While energy MLP ETFs also garnered strong net inflows from investors in 2013 at $4.4 billion, net inflows for traditional equity energy ETFs had been relatively weak in 2013 at $1.1 billion.
Renewed interest in the energy sector, which tends to perform better during periods of positive economic growth, is supported by several factors. The boom in US energy production, particularly for unconventional shale plays, has continued to gain steam over the past several years. According to the US Department of Energy, total US energy production satisfied nearly 84% of domestic energy consumption in 2013, compared to 70% in 2004 (Chart 4). Meanwhile, as the proportion of domestic production to consumption continues to grow, the Obama administration has begun to loosen a ban on crude oil exports that originally began in the 1970s, following the Arab oil embargo.
While the initial Commerce Department ruling that lifted the ban on exports of ultra-light oil known as condensate only applied to two companies, a broader loosening of restrictions could allow energy producers to potentially sell oil at higher prices overseas.7
ETF investors seeking exposure to the energy sector have several options:
- The First Trust Energy AlphaDEX Fund (FXN) provides broad exposure to the energy sector. This ETF tracks an index which employs the AlphaDEX methodology to construct a portfolio of energy companies selected from the Russell 1000 Index.
- The First Trust ISE-Revere Natural Gas Index Fund (FCG) is an equal-weighted equity ETF that provides exposure to companies that generate a substantial portion of their revenues from the exploration and production of natural gas.
- The First Trust North American Energy Infrastructure Fund (EMLP) is an actively managed ETF that provides exposure to energy MLPs and other publically-traded securities related to energy infrastructure.
- The First Trust NASDAQ Clean Edge Green Energy Index Fund (QCLN) is an ETF that provides exposure to companies engaged in the manufacturing, development, distribution, and installation of emerging clean-energy technologies.
- The First Trust ISE Global Wind Energy Index Fund (FAN) is an ETF that provides exposure to companies involved in the wind energy industry.
Taxable Bond ETFs
The third strongest ETF category for net asset flows during the first half of 2014 was taxable bond ETFs, which totaled $21.1 billion. Notably, the three strongest groups in this category were intermediate-term bond ETFs, long-term government bond ETFs, and corporate bond ETFs (Table 1 below).
The strength of net inflows for taxable bond ETFs in categories with longer durations8 reflected a renewed willingness on the part of investors to accept increased interest rate risk. This marked a reversal from 2013, when many of these categories had net outflows. This new disposition may be due to the easing of intermediate- and long-term interest rates during the first half of 2014, which sent bond prices higher. From 12/31/13 through 6/30/14, the yield on 10-year US Treasuries decreased by 0.50% from 3.03% to 2.53%, while the yield on 30-year US Treasuries decreased by 0.61% from 3.97% to 3.36%.
While intermediate- and long-term bonds play an important role in enhancing diversification for investment portfolios, we believe investors should not be complacent about interest rate risk in the months ahead. In our opinion, declining yields during the first half of 2014 may reflect a flight to safety in light of the weaker-than-expected -2.9% US real GDP growth rate in the first quarter. First Trust economists believe that an unusually rough winter was primarily to blame for this stall in economic growth. If growth accelerates during the rest of 2014, US Treasury yields may increase as well. By year end, First Trust forecasts 10-year US Treasury yields to reach 3.25%, and 30-year US Treasury yields to reach 4.05%.
Investors may choose to prepare for a potential increase in interest rates by reducing interest rate risk and potentially taking more credit risk in their bond allocations. ETF investors may consider the following ETFs from the First Trust ETF lineup:
- The First Trust Senior Loan Fund (FTSL) is an actively managed ETF which invests primarily in first lien senior floating-rate bank loans. Interest rate risk tends to be minimal for these securities due to their floating rate interest payments, while credit risk tends to be a more important consideration since borrowers’ credit ratings tend to be below-investment grade. As of 6/30/14, the fund’s weighted average effective duration was 0.75 years.
- The First Trust Senior Loan Fund (FTSL) is an actively managed ETF which invests primarily in first lien senior floating-rate bank loans. Interest rate risk tends to be minimal for these securities due to their floating rate interest payments, while credit risk tends to be a more important consideration since borrowers’ credit ratings tend to be below-investment grade. As of 6/30/14, the fund’s weighted average effective duration was 0.75 years.9
- The First Trust Preferred Securities and Income ETF (FPE) is an actively managed ETF that invests primarily in preferred securities. As of 6/30/14, the fund allocated 70.9% of its portfolio to fixed-to-floating rate securities10, which tend to have shorter durations than fixed rate securities. As of 6/30/14, the fund’s weighted average effective duration was 4.47 years.
- The First Trust Managed Municipal ETF (FMB) is an actively managed ETF that invests primarily in municipal debt securities which pay interest that is exempt from regular federal income taxes. As of 6/30/14, the fund’s weighted average effective duration was 6.84 years.
The weakest category of ETFs for net asset flows during the first half of 2014 was commodity ETFs, with net outflows totaling $459 million. However, this was a relatively small total compared to 2013’s net outflows which totaled $29.8 billion. Overall, precious metals ETFs were the strongest group during the first half of 2014 with net inflows totaling $228 million, despite $654 million in net outflows in the second quarter, which largely offset $882 million in net inflows in the first quarter. Broad commodity ETFs had the strongest net inflows in the second quarter, totaling $268 million.
As we’ve discussed in recent ETF newsletters and blog posts, we believe there are compelling reasons for investors to consider increasing allocations to this relatively unloved asset class. First, following a prolonged period of weak returns, we believe commodities may be due for a rebound. Second, commodities may provide a hedge against inflation. And third, the US economy may be entering (or already in) the phases of the business cycle during which exposure to a broad portfolio of commodities is most useful (namely the second half of expansions and the first half of recessions).
For ETF Investors seeking exposure to a broad portfolio of commodities:
The First Trust Global Tactical Commodity Strategy Fund (FTGC) is an actively managed ETF that provides exposure to a diversified portfolio of commodity futures. Unlike many other commodity ETFs, which issue K-1 tax forms, this fund intends to report taxable gains and losses on a Form 1099.
- The source for all estimated net asset flows data in this newsletter is Morningstar Direct.
- Recently reaffirmed by Mario Draghi, President of the European Central Bank, during a press conference in Frankfurt on July 3, 2014.
- Eurozone GDP Chain Linked 2005 Prices (SWDA, YoY%). SWDA is seasonally and working day adjusted (“working day” adjustments seek to smooth out the differences in business or trading days between different months).
- Eurostat Unemployment Rate- Eurozone (Seasonally Adjusted%).
- European Commission Consumer Confidence Indicator- Eurozone (Seasonally Adjusted, %Balance/Diffusion Index).
- June 2014 Monthly Energy Review, US Energy Information Administration.
- “U.S. Ruling Loosens Four-Decade Ban on Oil Exports,” The Wall Street Journal, June 24, 2014.
- Weighted average effective duration is a measure of a bond's sensitivity to interest rate changes that reflects the change in a bond's price given a change in yield.
- Includes short positions. A short position agrees to sell the asset when the contract expires and stands to profit as long as the underlying asset price goes down.
- A fixed-to-floating rate security has a coupon rate that is fixed for a certain period of time (typically five, ten or thirty years from the time of issuance), after which the coupon resets at a floating rate based on a spread over the security’s benchmark (typically 3-month LIBOR).
Past performance is not a guarantee of future results and there is no assurance that the events or improvements mentioned herein will continue