Goldman Sachs Sees Big ETF Inflows In 2018

As strong as inflows into equity ETFs have been this year, expect them to get even stronger next year. That's according to a new research report released this week by Goldman Sachs to clients, which forecast that inflows could surge 33% from this year's already-lofty levels.

Analysts at the investment bank also projected an increase in corporate buybacks for 2018, and signaled that demand for equities could receive an even larger boost if tax reform passes.

Inflows To Accelerate

The Goldman report said that investor demand for equity ETFs could climb from an expected $300 billion this year to $400 billion next year.

"The secular shift from active to passive management should persist next year, driving inflows into equity ETFs and outflows from mutual funds," said the report.

Indeed, while ETFs are expected to continue gathering assets at record speed, Goldman anticipates that equity mutual funds will see net selling of $125 billion on top of this year's $100 billion.

Goldman highlighted the fact that equity ETFs have seen inflows of more than $1 trillion since 2013, while equity mutual funds have had outflows of around $600 billion during the same period.

High costs and poor returns may be to blame for the shift from active mutual funds to passive ETFs.

"The challenging stock-picking environment due to low dispersion has contributed to weak active fund returns during the past few years" with "fewer than 50% of large-cap mutual funds [outperforming] their benchmarks in each of the past seven years," the analysts said.

Tax Reform Impact

Goldman added that if tax reform passes―a scenario that has a 65% probability of occurring, according to the investment bank―then ETF flows next year could be even greater than currently expected.

"ETF inflows would benefit from the potential for higher equity market returns" if tax reform happens, said the bank, while adding that mutual funds likely won't see any benefit from changes in tax policy.

Strong consumer balance sheets are another factor that may support ETF inflows next year. Household debt service as a percentage of disposable income is close to the lowest level since 1980, which gives retail investors more money to plow into exchange-traded funds.

ETFs Own 6% Of Market

As Goldman notes, retail investors are the most important holders of ETFs.

"The vast majority of ETFs are owned by retail investors," said the report. "Since 2009, ETF assets as a share of the total equity market (public and private) have doubled to 6% from 3%."

Separately, Goldman analysts pointed out that the influence of passive investments looks even larger when combining ETF assets with those of “index objective equity funds.”

"The combined value of ETF and index objective equity fund assets equal 14% of S&P 500 market cap and 9% of the total US public equity market," which illustrates "the magnitude of passive fund influence," they said.

Corporate Buybacks May Hit $600B+

Another source of equity demand that is expected to see a boost next year is corporate buybacks. Those may climb 3% in 2018 to $590 billion after falling 9% this year.

"An increase in repurchase authorizations, high cash balances, and positive earnings growth should support modest growth in corporate equity demand during 2018," said the repot. "However, high equity valuations, rising interest rates, potential policy uncertainty, and the underperformance of firms returning cash to shareholders should limit significant acceleration in buyback executions."

If tax reform passes, buybacks may rise even more next year, to $665 billion, implying 17% year-over-year growth.

"We estimated that firms would repatriate $250 billion of their total $920 billion of untaxed overseas cash next year. We expect $75 billion of the $250 billion repatriated cash would be spent on buybacks," the Goldman report said.

Other Sources Of Demand

Meanwhile, foreign investors are projected to remain net buyers of U.S. equities in 2018, but purchases may drop from $150 billion to $100 billion in 2018 as the dollar strengthens. At the same time, U.S. investors may purchase $250 billion worth of foreign equities in 2018, down modestly from $300 billion this year.

Pension funds may sell $250 billion worth of equities in 2018 as Treasury yields rise to 3.3%, making bonds more attractive, explained Goldman. Pension funds have sold an average of $200 billion worth of stocks each year since 2012.

Finally, households―a category that includes retail investors, nonprofits, endowments, domestic hedge funds, private equity funds and personal trusts―are anticipated to purchase $10 billion worth of equities in 2018, down from $30 billion this year.

Contact Sumit Roy at [email protected]