ETF watch: the big trends from Q2

With the IC’s Top 50 ETFs list and a round-up of thematic options both out last month, our latest quarterly analysis of trends in the sector has been somewhat delayed for the sake of variety. But the second instalment of our quarterly “ETF watch” reveals how investors are using passive funds to navigate some of the biggest market trends of the year.

Flows into exchange traded funds (ETFs) fell in the second quarter (Q2), but this should be seen in the context of two extremely strong previous quarters. Some of the most in demand ETFs this time round were old favourites which have run into rockier times in early 2021. The most popular of research provider Morningstar’s ETF categories were global and US large-cap funds targeting a mix of investment factors. When it came to individual funds, some of the most heavily bought names were mainstream and environmental, social and governance (ESG)-themed US equity ETFs, suggesting that the world’s biggest market has not exactly fallen out of fashion. Equally, some investors turned back to one of the decade's leading investment styles: some €1.2bn (£1.02bn) went into quality factor ETFs in Q2, a turnaround from a net outflow of €0.19bn in the previous quarter.

Flows into ESG ETFs slowed from a record €28bn in the first quarter to just over €13bn in Q2. The level of assets in ESG ETFs rose from €120.8bn to €140.4bn.

Yet Morningstar fund flow data also shows that ETF investors across Europe continued to reckon with the prospects of resurgent growth and inflation in the second quarter. As Jose Garcia-Zarate, associate director for passives strategies at Morningstar, puts it, it was “too early to say that investors may be losing faith in the post-coronavirus pandemic economic recovery” as the quarter drew to a close. Three of the top 10 ETFs by net flows in Q2 were value funds, with iShares Edge MSCI World Value Factor UCITS ETF (IWFV) in second place.

Value ETFs are now the second biggest factor subsector by assets under management, only sitting behind dividend ETFs. Some €3.74bn went into “value” products in Q2, compared with €5.28bn in Q1 – though this may simply reflect lower overall demand for ETFs. As we recently discussed, investors should look closely at the inner workings of factor ETFs, which can sometimes serve as a blunt tool.

Investors have continued to weigh up the threat of inflation in other asset classes. Morningstar notes that flows into bond ETFs amounted to €10.1bn across Europe in Q2, up from €4.3bn in the previous quarter. Importantly, they “poured money” into duration-shortening strategies to mitigate the risk of rising interest rates amid inflationary pressures. As the chart shows, half of the 10 best-selling bond ETFs offered exposure to bonds with limited duration, and another was focused on inflation-linked bonds in the US.

The chart is topped by iShares China CNY Bond UCITS ETF (CNYB), which tracks an index of Yuan-denominated bonds issued by China’s Ministry of Finance and policy banks. Having only launched in the summer of 2019 the fund has already ballooned in size: Morningstar noted in late July that it had already become the second largest bond ETF in the European market. The fund had more than $12bn (£8.69bn) across its different share classes in early June. In a year when Chinese equities have faltered, the ETF has held up relatively well, making a sterling total return of around 3 per cent in the first seven months of this year. By contrast, the CSI 300 index of Chinese equities was down by around 3.5 per cent in sterling terms over the same period.

Back to thematics

Thematic funds have seen a slowdown in investor demand but continue to play a big role in the ETF space. Having racked up a record €5.5bn in the first quarter, flows into thematics fell back to €1.9bn in Q2. That said, assets in thematic ETFs reached a fresh high of €32.4bn in the second quarter, up from €29.4bn in Q1.

If flows have fallen back, thematic ETFs continue to proliferate: nine launched in Q2 alone, compared with a record 17 launches for the whole of 2020.

As with other thematics, these names focus on niche but potentially promising trends and sectors, from industries of the future to potential Covid recovery plays. Very different examples from the first category include L&G Digital Payments UCITS ETF (DPAG) and Procure Space UCITS ETF (YODA). The digital payments ETF, unsurprisingly, has high allocations to the tech sector and the US, with 43 companies in the index it tracks. Some of these will be more familiar than others: its recent top 10 holdings include Shopify (US:SHOP), Paypal (US:PYPL) and Square (US:SQ). Other top holdings such as Zuora (US:ZUO) and Nexi (IT:NEXI) may be less well known. The top 10 holdings made up around a quarter of the fund’s assets at the end of June.

Procure Space ETF had 35 holdings at the end of June, including the likes of Virgin Galactic (US:SPCE) and Trimble (US:TRMB). Investors should note that, like some other thematic ETFs, it has a high fee of 0.75 per cent. As we recently discussed it also faces some competition from recently launched Seraphim Space Investment Trust (SSIT). The trust approaches the same theme in a notably different manner, with a focus on unlisted companies. The two funds are likely to carry different kinds of risk.

When it comes to Covid recovery plays, one option that emerged in the second quarter is Airlines, Hotels, Cruise Lines UCITS ETF (TRIP). The fund had 62 holdings at the end of June, with 44.1 per cent of its assets in airlines, 40.3 per cent in the hotel sector and 15.6 per in cruise lines. Its recent top holdings include Hilton Worldwide (US:HLT), Ryanair (RYA) and Carnival (CCL).

Another interesting ETF to launch in the second quarter was Saturna Sustainable ESG Equity HANzero UCITS ETF (SESP). An actively managed global ESG equity fund, it stands out for incorporating carbon offsetting in its processes. Carbon offset specialists will work with HANzero, HANETF’s carbon offsetting brand, to neutralise carbon emissions via projects focusing on issues such as forest conservation.

The fund positively screens for ESG factors such as companies demonstrating excellent corporate governance, and a commitment to reducing environmental impact in the areas of carbon emissions, water and waste.