Beyond Bulls & Bears

ETFs

ETF trends to watch in 2023: Active munis, global appeal and dividend funds

With January being a month for prognostications, David Mann, Head of Global Exchange-Traded Funds (ETFs) Product and Capital Markets, shares his annual outlook for the ETF industry and key trends he sees taking shape in 2023.

First, I hope everyone had a wonderful New Year and was able to find time to recharge the batteries. I do not want to go too far off topic—given this is an ETF newsletter—but I do wonder sometimes if vacationing with the kids qualifies as a relaxing break from the normal daily grind.

This is my seventh (!) year of giving ETF-related predictions. Last year’s predictions were disappointing from an accuracy perspective, and I suppose I should be grateful to my good friends on the Franklin Templeton grading committee for kindly giving me a D- rather than flunking me for my disastrous environmental, social and governance (ESG) ETF call. I reread all six prior columns and think I have a decent sense of which themes I should focus on for better success in 2023. As always, this is an ETF predictions column, so there will be no market calls on interest rates or S&P 500 Index end-of-year levels.

  • Active muni funds will be the active fixed income ETF story of the year

I have discussed active ETFs numerous times over the life of this newsletter, including my 2021 predictions column written on the back of the passage of the ETF rule. Active fixed-income ETFs allow portfolio managers to stay nimble and avoid sectors and parts of the credit spectrum that might encounter increased stress, all while leveraging the same creation/redemption operational efficiencies used by index funds. That fact most certainly applies to municipal bond ETFs.

Last year was a fascinating one for municipal bond funds, which have recently been the topic du jour in both media and broker/dealer research reports. The asset class felt similar pain as other fixed income exposures, so it was no surprise to find significant outflows in 2022. However, within these outflows there was a fascinating sub-narrative: Municipal bond mutual funds saw outflows of over $140 billion, while municipal bond ETFs saw inflows of almost $30 billion.1

The ETF industry has speculated that the municipal bond market is finally starting to appreciate all the trading, liquidity and operational efficiencies offered by the ETF vehicle, especially given the broader fixed income market structure developments in recent years. I think that is a huge tailwind for municipal bond ETFs, especially those with active management.

Active municipal bond ETFs currently represent roughly 10% of the overall municipal bond ETF market, which stands at a little over $100 billion.2 Last year, those active funds represented roughly 8% of municipal bond ETF inflows.3 I see the overall municipal bond ETF pie continuing to grow and active management increasing its share of that pie. I predict that more than 20% of municipal bond ETF inflows in 2023 will be directed toward active funds.

  • Equity dividend ETFs find a broader audience

The equity ETF market in the United States is gigantic with approximately $5 trillion of total assets across over 2,000 funds.4 The three largest of these equity ETFs each track the S&P 500 Index, charge an average management fee of ~5 basis points and account for a staggering ~20% of all equity ETF assets in the United States.5 For many investors, these three ETFs alone represent a core holding in their overall portfolio.

Dividend ETFs represent a far smaller slice of the equity ETF pie with approximately $370 billion of assets and just 7% of total equity ETF market share.6 These ETFs have been quite popular with yield-starved investors, both as an alternative to bond funds and as a portfolio stabilizer during times of heightened market volatility.

I would never associate dividend investing with a core holding. However, the evolution of index investing is never-ending, so it’s not surprising that these two worlds are starting to converge. The majority of initial dividend indexes were designed to maximize income, and that can lead to unintended risks, such as single-security or sector bias. The latter could mean that investors miss out on broad market economic growth drivers across a particular market cycle. Put another way, investors can now contemplate how much deviation from the market portfolio they are willing to take for additional yield.

There are now a growing number of dividend ETFs that are focused on yield and offer responsiveness to evolving sector dynamics of the broader market. Let’s call these “core dividend” ETFs. As more retail investors approach retirement, dividend ETFs—as previously constructed—will continue to be popular. Additionally, as more investors appreciate newer dividend strategies that could serve as a core holding, the assets under management growth potential significantly increases. I predict that 15% of equity ETF inflows come from dividend ETF strategies.

  • ETFs that hold international equities shine

Last year, my prediction on international equity ETF investing was focused on potential supply-chain woes causing significant performance dispersion among global equity markets. In my report card, I noted that the strength of the US dollar in relation to local currencies weighed on the performance of global equity ETFs.

I estimate that approximately 20% of equity ETF assets in the United States exclusively hold international equities. The flows into these funds have been surprisingly consistent with the one-year, three-year, and five-year percentages all around 24%.7

I think there are some real reasons for global optimism. Although not entirely behind us, pandemic problems now seem to be less impactful globally compared to the past couple of years. Local currencies seem to have stabilized (or even strengthened) in relation to the US dollar. Developed European markets did well during the fourth quarter of 2022, as the euro and the British pound both advanced 9.2% and 8.2%, respectively. Japan’s yen also appreciated 10.4% against the US dollar during the final quarter, helping the FTSE Japan RIC Capped Index rise nearly 13%.8

Latin American markets were a bright spot during 2022, given strong currency performance relative to the US dollar. Brazil was a clear winner among major equity markets with the FTSE Brazil RIC Capped Index ending the year up 12.2%.9 Mexico’s equity market, as measured by the FTSE Mexico RIC Capped Index, also ended in the green with a fourth quarter rally of 13.9%.10 Investors have also been returning their focus to Chinese equities in recent weeks amid growing convictions that government relaxation of Covid-19 restrictions could soon fuel a resumption of consumer spending. The FTSE China RIC Capped Index was up about 13% for the fourth quarter of 2022.11

Supply chain woes appear to be abating, potentially easing global inflationary pressures. US equity markets are still trading at much higher valuations than almost all other global markets, and this could spur bargain hunting.

Put that all together, and I think this year we should finally see momentum for ETFs that hold international equities. I predict they will account for more than 40% of equity ETF flows in the United States.

Will these predictions play out? Stay tuned!

WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Generally, those offering potential for higher returns are accompanied by a higher degree of risk. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. For actively managed ETFs, there is no guarantee that the manager’s investment decisions will produce the desired results.

ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.

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1. Source: Morningstar as of 12/31/22.

2. Ibid.

3. Ibid.

4. Ibid.

5. Ibid.

6. Ibid.

7. Source: Ibid.

8. Sources: Bloomberg and Morningstar Direct as of 12/31/22. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator of future results. See www.franklintempletondatasources.com for additional data provider information. The FTSE Japan RIC Capped Index represents the performance of Japanese large- and mid-capitalization stocks.

9. Ibid. The FTSE Brazil RIC Capped Index represents the performance of Brazilian large- and mid-capitalization stocks.

10. Ibid. The FTSE Mexico RIC Capped Index represents the performance of Brazilian large- and mid-capitalization stocks.

11. Ibid. The FTSE China RIC Capped Index represents the performance of Chinese large- and mid-capitalization stocks.

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