3 ETF Predictions For Rest Of 2015

We stare into our crystal ball for what's ahead for the rest of the year.

Reviewed by: Matt Hougan
Edited by: Matt Hougan

[This article originally appeared in our August issue of ETF Report.]

At the start of each year, we like to gaze into the crystal ball and forecast the most exciting developments coming to the ETF space. But there is so much going on this year—record flows, new launches, the prospect of exchange-traded flows, new launches, the prospect of exchange-traded managed funds—that I thought it worthwhile to take a midyear snapshot as well.

Here are three themes that will shape the ETF market in the second half of the year.

Nº 1 Investors Will Look Abroad
If one trend stands out among ETF investors recently, it is their love afor international stocks. ETF investors poured $48 billion in net new money into international equity ETFs in the second quarter alone. For reference, that's more than they invested in international equities in all of 2014. Who cares about a collapsing Greece, a challenged Russia or a bubble bursting in China?

There were roughly $15 billion of inflows into currency-hedged ETFs, led by the most popular ETF of the quarter, the Deutsche X-Trackers MSCI EAFE Hedged Equity ETF (DBEF | B-65), which attracted $5.5 billion in inflows.

But really, the flows came from every direction. Eight of the top 10 ETFs for inflows in the second quarter were international equity funds, including the boring-as-dirt iShares MSCI EAFE (EFA | A-93), which pulled in $4.3 billion. Japan, China, Germany, India, Hong Kong and Spain were among the single-country funds seeing lots of love.

In all, 28 international equity ETFs had more than $500 million in inflows for the quarter, while zero had that much in outflows. The worst was the iShares MSCI Brazil Capped ETF (EWZ | B-96), which lost $335 million as that nation tumbled toward economic chaos.

This trend will accelerate in the second half of the year, thanks to three big factors driving this growth:

The Rise Of Currency-Hedged Etfs

Currency-hedged ETFs were the biggest story of the first half of the year, and with industry behemoths like BlackRock and ProShares launching their own currency-hedged ETFs recently, there's no reason to expect things to slow down.

More than anything else, currency-hedged ETFs are an easy sale for advisors. Every day, it seems, there is a terrible headline about Europe in the Wall Street Journal. Meanwhile, for the year ending June 30, 2015, currency-hedged exposure to the EAFE Index outperformed nonhedged exposure by more than 14%.

Advisors are always looking for ways to appear smart to their clients. Is there an easier way than calling them up to talk about currency-hedged exposure?

International Markets Remain Cheap

Despite the flood of inflows, international equity markets remain cheap in comparison with the U.S. Based on data from FactSet, the broad U.S. market was trading at a price-to-earnings ratio over 21 as of June 30. By comparison, the developed international market was trading at just 18.6, and emerging markets were trading under 10.

It'll be interesting to see how flows into the beaten-down emerging market space develop in the second half of the year. Will the bursting of the China bubble scare investors off, or will bargain hunters emerge? Emerging markets had $5 billion in net new flows in the second quarter.

Bet on net inflows as investors abandon the U.S. and start looking around for a bargain.

Worries About The Us Bull Market

On an anecdotal basis, we're hearing increased concerns that the U.S. equity bull market is long in the tooth. Virtually none of the presenters at ETF.com's Global Macro conference in June wanted anything to do with U.S. equity markets, preferring to embrace former laggards like Spain, Italy and Japan. Normally, I'd discount my anecdotal experiences, but in this case, they line up with the data.

Nº 2 Bond Investors Are Going To Freak

Fixed-income ETF investors are frozen right now. For the past few years, fixed income has been the hottest place for flows in the ETF market. In 2014, for instance, investors put more than $50 billion to work in U.S. fixed-income ETFs. In the second quarter of 2015, that number slowed to just $135 million.

It's not that people stood pat. They yanked $4.5 billion out of high-yield bond ETFs, fled 20-plus-year Treasurys and lightened up on investment-grade bonds. Instead, they put money to work in some of the most boring funds in the world: The iShares Core U.S. Aggregate Bond ETF (AGG | A-98) brought in $1.5 billion in new assets in Q2. The iShares 1-3 Year Treasury Bond ETF (SHY | A-97) netted $1.3 billion. And the iShares TIPS Bond ETF (TIP | A-99) pulled in $952 million, despite yielding essentially zero, with no prospect for inflation on the horizon.

The move out of high-yielding funds and into placeholders leads me to believe investors don't know what to do. The easy trades are all done now, and investors are just waiting for rates to do something.

Two ETFs worth keeping an eye on in this market include:

SPDR Doubleline Total Return Tactical Bond ETF (TOTL)
We predicted in January that TOTL would be a big success in 2015, and while it hasn't attracted assets the way we expected it to, there's still time. The fund—run by bond superstar Jeffrey Gundlach—has performed well, outperforming funds like AGG and the PIMCO Total Return fund (BOND | B), and it offers investors a way to offload the decision-making process to an internationally respected bond superstar.

Market Vectors High Yield Municipal Bond ETF (HYD | C-59)
As uber-advisor Richard Bernstein is quick to point out, high-yield munis offer a better yield than the bonds of Lebanon right now, and are just a smidge more expensive than Iraqi bonds. With the economy still doing well and tax receipts coming in, getting a 5.5% tax-free yield on some decent credits could be attractive.

Nº 3 The Big Boys Come To Market

The ETF industry grew up in a bit of a Vacuum. It was dominated in the early days by index geeks and investing purists looking to offer low-cost beta products in a convenient package. Barclays Global Investors, Vanguard, State Street and similar firms established dominant positions in the market.

But the industry is evolving. Today smart-beta strategies that bridge the active/passive divide are in the crosshairs of investors. Moreover, the industry has become too big for the established asset managers to ignore.

The next few months are shaping up to be a watershed moment for the industry, when large, established managers get into the market in a major way.

We've already seen this happen to some degree. Charles Schwab is now the 7th-largest provider of ETFs in the U.S., with $35 billion in assets, after a dead start a few years ago. Deutsche Bank has built up a $19 billion ETF business in the U.S. in a surprisingly under-the-radar way, while J.P. Morgan, Janus and others have all dipped their toes into the water.

But the floodgates are about to open. Goldman Sachs Asset Management has spent the past 12 months hiring every great ETF expert available on the market, and is said to have a significant budget supporting its pending entry into the space.

John Hancock, Manulife, Legg Mason and Preferred Financial, among others, are all looking to make some noise soon. And if you include exchange-traded managed funds, you have to add Eaton Vance, Gabelli Funds, Pioneer Investments, Hartford Funds and others are in the mix.

Those are big names, and they could all enter the market in the next 12 months. When you add them to the pile of people already talking about ETFs, you can see the pace of growth accelerate quickly.

Contact Matt Hougan at [email protected].

Matt Hougan is CEO of Inside ETFs, a division of Informa PLC. He spearheads the world's largest ETF conferences and webinars. Hougan is a three-time member of the Barron's ETF Roundtable and co-author of the CFA Institute’s monograph, "A Comprehensive Guide to Exchange-Trade Funds."