2021 a record year as ETFs continue to hit new highs

2021 was a record year for flows into Australian exchange traded products (ETPs) despite the COVID-19 pandemic. The main drivers of the move to ETFs were investors' desire to gain exposure to booming share markets especially US equities, strong thematic trends such as clean energy and sustainable investing, which are expected to remain dominant in 2022.

Over the 12 months to November 30, 2021, the Australian exchange traded product (ETP) industry jumped in size by 44% to a record $132.66 billion. With stock markets having experienced an especially strong year, and US share markets striking record highs, this helped to attract record net flows into the ETP market of over $24 billion over the year to November 30, well ahead of 2020 net flows over the same period of around $20 billion. ETFs make up around 90% of the Australian ETP market.

Investors continue to be attracted to ETFs due to their liquidity advantages, transparency and lower costs. As the industry has grown, the range of ETFs has increased from benchmark tracking ETFs to active ETFs . With this expanding range of products, we believe even more funds will flow into the ETP market next year, which could take it to a market capitalisation of over $200 billion.

Several other factors have fed this record level of inflows into ETPs. Many Australian investors have turned to international equity ETPs to gain exposure to shares listed offshore given strong rises in asset prices, fueled by ultra-accommodative monetary and fiscal policy resulting in record low interest rates.

Inflows into international equity ETPs totalled $12.87 billion over the 12 months to November 30, much higher than flows into Australian equity at $5.82 billion. Many Australians used ETFs to gain exposure to the US share market, which has boomed this year, outperforming the Australian bourse.

Smart beta gains in importance

In recent years, the range of ETPs has increased from simple market capitalisation index-tracking ETFs to smart beta ETFs. Smart beta ETFs track non-market capitalisation weighted indexes designed with investment outcomes in mind that can include active strategy approaches like 'factors' such as investing in quality or value stocks or companies with a high ESG rating. Smart beta ETFs effectively combine the best of active and passive investing, with the potential for outperformance while being rules-based and cost efficient.

Reflecting their appeal and the appeal of thematic ETFs, flows to smart beta ETFs have been especially strong this year, totalling $4.74 billion over the 12 months to 30 November 2021, accounting for 20% of all ETP inflows. Smart beta funds under management (FUM) totaled $19.06 billion as at November 30. Smart beta market share is likely to grow further in 2022 as many active fund managers struggle with underperformance and consumers walk away from their relatively high fees.

The most recent research from S&P Dow Jones Indices, the SPIVA Australia Scorecard, found that over three, five, 10 and 15 years to June 30, 2021, the majority of active funds underperformed their respective benchmark indices across categories, except for Australian equity mid- and small-cap funds. This is a long-term trend and likely to push even greater flows into the ETF market in 2022.

Boom in thematic ETFs

Investors have also directed more money into Australian sustainable ETFs, with flows totaling $800.8 million, and assets under management (AUM) topping $2 billion this year (12 months ending November 30, 2021).

Moving forward, more ETFs focused on environmental, social, and corporate governance (ESG) factors are likely to be launched on ASX in 2022 as investors' awareness of social and environmental themes such as climate change grows. Investors should be weary of 'green-washing' and determine if the claims made by the fund manager are true-to-label.

Related to this, more thematic ETFs are likely to emerge in 2022. Thematic ETFs can be used by investors to capture targeted opportunities where there is government policy or societal changes directing a flow of capital. Examples of investment themes underpinning ETFs include clean energy, video gaming and technology sectors, which is drawing in the younger demographic and more sophisticated investors alike, driving growth of the ETF market overall.

These themes too are likely to endure over the long term as they are underpinned by long term structural or economic trends. Investors should avoid ETFs exposed to niche or esoteric themes, as they may have a short-term life compared to thematic ETFs underpinned by long-term structural trends.

Positioning for higher inflation

Another emerging theme for 2022 will be the need for investors to protect against persistently higher inflation. With the Federal Reserve accelerating tapering and a number of expected rate rises in the US investors would be wise to ensure their portfolios can mitigate higher discount rates which impact valuations.

Assets that generally perform well through periods of higher than average inflation include gold and gold shares and real estate investment trusts (REITs). On the other hand, fixed income ETFs are likely to face more difficult times in 2022 as rising inflation could bite into the value of corporate and government bonds.

However, bonds with floating-rate coupons and emerging market bonds could perform better in a higher inflation environment. Selectivity is now essential.

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