- The equity rally pushed ETF assets in Europe to a record level
- But it was also the year of government bonds
- Sustainable ETFs proved less popular as before
The end-of-year rally changed the market narrative of 2023 in many ways, transforming a lukewarm year for certain investors into a solid one. This was also the case for exchange traded fund (ETF) flows across Europe, particularly into stock market vehicles, which picked up significantly in the last three months of the year.
European investors poured €45.7bn (£39bn) into ETFs and exchange traded commodities (ETCs) between October and the end of December 2023, up from €31.4bn in the third quarter of the year and €28.1bn in the second, according to Morningstar data. The total for the year amounted to €143.9bn, the second-highest ever for the market – only 2021 was stronger. Helped also by market performance, European ETFs closed the year with record assets under management of €1.6tn.
This speaks to the rebound equities experienced towards the end of 2023, as well as confirming the popularity of passive strategies in a year where the US and world markets in particular were very narrow – meaning just a few stocks produced most of the gains – making it difficult for active managers to beat their benchmarks. In the UK, £9bn has been withdrawn from active open-ended funds and £75bn flowed into passive strategies over the past five years, according to AJ Bell analysis of Investment Association data.
Laith Khalaf, head of investment analysis at AJ Bell, says there is a question over whether passive investing is becoming “a bit of a self-fulfilling prophecy”. “Passive flows allocate money to markets simply based on company size, rather than fundamentals,” he explains. “This helps support the share prices of the big at the expense of the little, thereby rewarding passive strategies.”
Passive strategies then attract even more flows, and the cycle continues. Just 36 per cent of active managers beat the average passive equivalent in 2023 across seven key equity sectors, according to AJ Bell analysis, although this was up from 27 per cent in 2022.
Equities are back
It was a strong year for flows into both equity and fixed-income ETFs. The chart below shows how fixed-income flows were comparatively regular throughout the year, albeit with a dip during the third quarter, while investments into equity ETFs really picked up between October and December.
The two most popular equity categories among European ETF investors in the fourth quarter were US and global large-cap blend equities, the latter of which also have significant exposure to the US market. No surprises there, given how the ‘Magnificent Seven’ stocks dominated markets and headlines. The two categories combined account for 45.8 per cent of all assets invested in equity ETFs.
But European and Japanese equities also made the top five. Jose Garcia-Zarate, associate director for passive strategies research at Morningstar, describes inflows into Japan as “a remarkable outcome for an economy that has been a byword for stagnation for the best part of the past three decades”.
“Investors have been encouraged by the policy drive to improve Japanese corporate standards – and ultimately valuations – while some may have seen in Japan a less risky Asian investment proposition than its troubled Chinese neighbour,” he suggests.
Meanwhile, German and UK equities made an appearance among the 10 least popular categories. UK large-cap equity ETFs saw €1.2bn of outflows in the quarter. The UK and Germany were “afflicted by lame export growth and self-inflicted wounds, respectively”, Garcia-Zarate comments. Other unpopular areas among equity ETF investors included the financial services sector, China and various value investing strategies.
More bonds, less gold
With €57.2bn of inflows, fixed income ETFs had their best year in the past decade. Garcia-Zarate says that “the fixed-income story of 2023 was the return of government bonds into investors' portfolios”.
“Many of these investment bets, particularly those with higher duration, have been lossmaking in the short term as the price of bonds moves inversely to interest rates. So, it seems that investors have taken a long-term view when reshaping their bond market allocations,” he notes.
Several short-term bond categories experienced outflows in the fourth quarter, hinting that investors expect interest rates to come down at some point soon. But cash-like investments remained popular, and money-market ETFs netted €5.1bn of inflows over the course of the year, strongly up from €1.9bn in 2022 and €400mn in 2021.
Meanwhile, commodities had another bad quarter and the worst year in a decade, with outflows totalling €9.2bn. This was chiefly driven by precious metals. “Gold is a classic safe haven for investors, particularly at times of rising prices, and so these outflows may be indicative of a more positive stance regarding the future path of inflation. One should hope that the harsh medicine doled out by central banks in 2023 would work,” Garcia-Zarate says.
Waning ESG?
As we have previously discussed, funds investing with an environmental, social and governance (ESG) tilt followed up a poor 2022 with a lukewarm 2023, displaying mixed performance and weak flows. The picture for ESG ETFs also looks mixed, if somewhat brighter.
Flows were still positive at €42.3bn in total during the year, but this was down from €51bn in 2022 and €84.2bn in 2021. In 2022, ESG accounted for 64 per cent of total flows into European ETFs. Last year, it was down to 29 per cent.
This seems to confirm that the ESG trend is weakening and investors have grown wary of it after the sector’s poor performance in 2022. But Garcia-Zarate says concluding that ESG has gone out of favour would be premature, given that “short-term caution doesn’t necessarily equate to long-term aversion”. He also notes that a significant portion of 2023 flows went into government bonds, an area where ESG integration is very difficult.
Meanwhile, active ETFs remain niche but are getting more popular, with €6.7bn of inflows in 2023, up from €2.4bn the year before.
“While ETFs have been traditionally identified as passive funds, the reality is that an ETF is just a vehicle, and there's no obstacle for active strategies to be distributed in it. An active ETF would benefit from real-time stocklike pricing, ease of transaction, and lower management costs than a traditional active mutual fund,” says Garcia-Zarate. Meanwhile, the thematic ETF trend continues to slow, with €700mn of flows in the sector in 2023 against €1.3bn in 2022 and €11.2bn in 2021.
The final point of note is that in October 2023 State Street reduced some of its ETF fees, and the SPDR S&P 500 ETF (SPX5) is now the cheapest S&P 500 ETF on the European market, after costs were cut from 0.09 per cent to 0.03 per cent.
