Flow & Tell with iShares | October 2023

October ETF heat map

October ETF flows compared with index performance

Highly sensitive to interest rates, badly beaten, and posting double-digit negative returns — an unlikely descriptor for one of October’s favored allocations. Despite sharply negative performance, long-dated bonds remain top asset gatherers as traders continue to ‘buy the dip,’ wagering that interest rates may have peaked, and slated to move in the opposite direction.¹

Flows historically follow performance — an intertwined relationship that underscored October’s equity allocations. But the reverse played out in bond exposures as investors flocked to long-term U.S. Treasuries, which boast a higher duration — indicating a greater price sensitivity to interest rate shifts — and is poised for upside if yields subside. TLT (iShares 20+ Year Treasury Bond ETF) is one way investors can gain exposure to this contrarian viewpoint, notching a record $20.1bn year-to-date, the third most inflows out of all 3,322 U.S.-listed exchange-traded funds.² These historic inflows were met with steep losses: long-dated funds have returned -14.01% on the year, and near -5% in October alone as interest rates climbed, not declined.³ Still, the potential reward attracted dip buyers: the aforementioned TLT took in its second largest weekly inflow YTD in the third week of October, complete with two consecutive days of inflows over $1bn each.⁴

Fall brings a cornucopia of opportunity for harvest enthusiasts: from squash to pumpkins to lattes. But an important one that is sometimes overlooked is taxes. Tax-loss harvesting is a strategy in which investors sell stocks, bonds or funds at a loss and invest the proceeds in a correlated instrument — thereby locking in losses to offset a current or future capital gain while maintaining market exposure.

Slumps in bond prices offer ample tax-loss harvesting opportunity: the majority of core bond funds are down over 3- and 5-year periods, with the average 3-year price return at a spooky -22%.⁵ Opportunities are not exclusive to bonds, either — a high degree of dispersion in equity markets, with a small number of big winners masking broader losses, means even certain equity funds are underwater for the year.

Sizeable flows underpin tax-loss harvesting trades over the month, especially prominent in tax sensitive areas of the market: municipal bond ETFs posted its largest monthly inflows on the year (more than 2.5x the rolling monthly average!) in October as investors adjusted allocations.⁶

Of the $146bn of inflows into bond ETFs year to date, $98bn has been into government exposures, followed by $47bn into broad, multi-sector ETFs.⁷ Continuing the trend we noted in September, investors have maintained a preference for higher quality fixed income exposures. What may be more surprising is the third biggest inflow category: ETFs that mature.

Term maturity ETFs were first created in 2010 to allow ETF investors to build bond ladders — as they would with individual bonds — with the exchange trading and diversification features of ETFs. These ETFs create portfolios of bonds maturing in given calendar years and de-list after all the bonds in the portfolio mature. Investors increasingly appear to be using them to target specific points on the yield curve, or to ‘lock in’ elevated yield levels as the Fed approaches the end of its hiking cycle.

The quality bias in this year’s flows is evident in these structures too: 83% of flows have been into investment grade corporate and U.S. Treasury term maturity ETFs.⁸ We estimate that approximately $8bn of term maturity ETF assets under management are set to de-list by December.⁹ Over the coming months, many investors will likely choose between waiting and receiving cash upon maturity or trading out early and potentially extending to other rungs on the ladder. They can do it on their own terms.