5 Hot ETF Trends That Are Cooling Down

Some of the most popular ETF trades this year seem to be cooling down. The shift in momentum is a case of mean-reversion triggered by valuations and overcrowding—too many people chasing the same strategies.

We’re talking about these five pockets of the ETF market:

• Dividends
• Utilities
• Low Volatility
• REITs
• Gold

A look at asset flows and performance in these segments points to a slowdown if not a complete change in momentum. To Wes Gray, head of Alpha Architect and an active manager, this all has to do with value.

“After a cooling down period, on a fundamental basis, the median PE [in most of these segments] is already now more in line with the broader market, so one could argue this was a valuation mean-reversion effect,” Gray said.

How much in line? The median price/earnings ratio on the SPDR S&P 500 (SPY) is now 20.82. The PE on some of the biggest ETFs in each of these segments—funds such as the Vanguard Dividend Appreciation Index Fund (VIG), the Utilities Select Sector SPDR Fund (XLU) and the PowerShares S&P 500 Low Volatility Portfolio (SPLV)—are now all “in that ballpark of SPY [SPDR S&P 500 ETF Trust (SPY)],” Gray said.

But REITs, as measured by what’s going on with the Vanguard REIT Index Fund (VNQ) “are still at high valuation ratios,” he said, even with the recent slowdown.

Some key points to consider specifically about each segment:

Dividends

The Vanguard Dividend Appreciation Index Fund (VIG) and the iShares Select Dividend ETF (DVY) have together attracted more than $2.5 billion in net inflows year-to-date. Combined, the two ETFs—the largest in the ETF dividend space—have more than $38 billion in AUM.

But since Sept. 1, the pace of asset inflows has significantly slowed down. The two ETFs have attracted less than $100 million combined in the past six weeks or so. Hand in hand with the slowdown in net inflows has been range-bound price performance, as the chart below shows. 

The dividend space is suffering from two problems. One is what David Dziekanski, portfolio manager at Toroso Investments, calls over-ownership. Popularity of this trade has led to overconcentration. In the case of a mass exodus, things could get ugly quickly.

The other is a lack of fundamental support to back up lofty values.

“Big dividend stocks are stretched out, and they don’t have the growth prospects to keep this going,” he said. “There’s some overconcentration in this segment, and lack of fundamental support going forward.”

According to him, a lot of companies have been artificially raising dividends, stretching themselves too much, and hurting their ability to grow earnings and put money into research and development, “which is the future of their business.”

Utilities

Utilities is one of the good-old defensive positions in a portfolio, and one that generates income. But its defensive power is directly linked to value.

From a valuation perspective, many utility ETFs and stocks may still appear cheap relative to other areas of the market, but they are expensive compared with their historical norms in relation to the broader market, Dziekanski says, noting that “there’s less defense built into these positions because a lot of people are piling into that trade.”

According to data provided by Gray, the median PE for a fund like the Utilities Select Sector SPDR Fund (XLU)—the largest utilities ETF—is around 18.8, just below that of SPY.

But this sector is also sensitive to what the Federal Reserve does. The market seems to believe a December rate hike is almost a sure thing, and utilities are very rate sensitive because they are income-generating, and with high yields. But in an environment where rates on Treasurys—which are risk-free—are going up, utilities just look less attractive.

In the first eight months of the year, the two largest utilities ETFs—XLU and the Vanguard Utilities Index Fund (VPU)—had attracted more than $1.65 billion in combined assets. But since Sept. 1, they’ve both faced redemptions, bleeding $280 million and $12 million in assets, respectively.

The chart below shows their performance trajectory year-to-date. The ongoing correction is starkly clear: 

Low Volatility

Low-vol ETFs are suffering from similar problems: over-ownership, and overpricing. Like utilities, the hugely popular trade is overcrowded, some say, and from a valuation perspective, expensive too.

“There’s more downside risk here because of over-ownership of these strategies,” Dziekanski said.

The PowerShares S&P 500 Low Volatility Portfolio (SPLV) has faced outflows of more than $656 million since Sept. 1, while the iShares Edge MSCI Min Vol USA ETF (USMV) has bled about $610 million in the same period. USMV had been on tear, ranking as one the top three most popular ETFs this year, with net creations exceeding $11 billion. 

REITs

REITs became their own equity sector this year under GICS [the Real Estate Select Sector SPDR Fund (XLRE)] in an event that triggered significant inflows into the segment. But now, it looks like REIT ETFs are facing a reset.

“REITs are tricky area right now,” Dziekanski said. “Between passive ETFs and the mutual fund space, there’s a massive over-ownership of REITs relative to other asset classes. This is something we’ve been concerned about for a long time.”

As he put it, any exposure that deviates from owning the broad market—such as REITs—face the risk of coming off the rails first in the case of a market correction. They are more tactical in nature, and investors get spooked more easily.

Year-to-date, the Vanguard REIT Index Fund (VNQ) has seen net inflows of $4.4 billion, but the rising needle has given up some ground in the past six weeks as the fund faced redemptions of $146 million. The competing iShares U.S. Real Estate ETF (IYR) has bled more than $600 million since Sept. 1, putting its year-to-date asset gains in negative territory.

The outflows have come as these funds struggle to find upside after recent highs in August, as the chart below shows. And if you consider that the median PE on VNQ is still around 45—compared that to 20.87 for SPY—these stocks are still overpriced, Gray points out. That could mean more downside to come. 

Gold ETFs have had a blockbuster year, posting double-digit gains amid massive net creations. The SPDR Gold Trust (GLD) has, in fact, been the most popular ETF in 2016, raking in a net of $12.55 billion in inflows.

The iShares Gold Trust (IAU) and the VanEck Merk Gold (OUNZ) have also seen positive inflows, of $2.9 billion and $65 million, respectively, year-to-date. But the pace of creations seems to be slowing down. In the past six weeks, GLD took in about $660 million, and some worry that its faltering performance of late could trigger more outflows.

Like other segments, the surge in investor demand for these ETFs has left the space overcrowded. And the outlook for a rate hike in December and then again next year isn’t boding well for gold either. Many investors own gold as an inflation hedge, but higher interest rates tend to discourage inflation.

Physically backed gold ETFs have yet to retest highs seen late in July, and have given up significant ground in recent weeks as the chart below shows:

Charts courtesy of StockCharts.com

Contact Cinthia Murphy at [email protected]