For long-term investors, exchange-traded funds present a low-cost, efficient way to put their money into a wide variety of different types of investments. But because ETFs are extremely popular among short-term traders, they also provide valuable information about market sentiment and what direction traders expect the market to move next.
Overall, ETFs have grown strongly over the years, going from a once-fledgling market to top the $1 trillion mark in assets under management. Given the persistent popularity of ETFs, net outflows tend to be rare -- and some might look at them as a sign of coming trouble for the financial markets.
Where the dough is flowing
Birinyi Associates reported yesterday that ETFs suffered a net outflow of $1.1 billion in May. That's the first time more money has left ETFs than has come in since last August.
In particular, the research firm cited commodity ETFs and U.S. stock ETFs as the primary contributors to the net outflow of ETF assets, with the broad-market SPDR S&P 500 (NYSE: SPY), the silver-tracking iShares Silver Trust (NYSE: SLV), and the financial sector ETF SPDR Financial Select Sector ETF (NYSE: XLF) among the volume leaders for the month. In contrast, bond ETFs saw significant inflows.
Closing the barn door
Those moves seem consistent with the market correction that we've already seen. The question, though, is whether ETF outflows have any predictive value for the future, or if they merely represent performance-chasing investors who are selling only after the damage has been done.
To answer that question, consider the following:
- The last month that had ETF outflows, August 2010, happened to be a big down month for the market. At the time, many believed that the seasonally weak months of September and October would continue the downward trend. But as it turned out, the market proved them utterly wrong, producing a huge rally that pushed the S&P 500 up almost 9% in September and more than 25% during the following six months. Then, predictably, ETF inflows jumped back up.
- The price of silver plummeted in early May, with nearly all of the damage done by May 5. ETF investors who got out of silver after that merely locked in losses -- and those who stuck it out saw prices rebound more than 10% by the end of the month.
- Making too much of a $1.1 billion outflow would be silly, given that it represents less than 0.1% of the $1.12 trillion in ETF assets under management.
Moreover, the past track record of fund flows is suspect. In the first three months of 2011, money flowed out of emerging-market ETFs iShares MSCI Emerging Markets (NYSE: EEM) and Vanguard MSCI Emerging Markets (NYSE: VWO) as the funds' big share price rises started to stall out. Even as the ETFs rallied in March, outflows continued -- until April, when investors suddenly loved emerging markets again.
Following the fads
Even Birinyi's report suggests that investors seem to be following fashionable investing trends rather than predicting a downturn. Despite overall outflows from U.S. stocks, Birinyi cited big inflows for dividend-oriented ETFs. Since dividend ETFs SPDR Dividend (NYSE: SDY) and Vanguard Dividend Appreciation (NYSE: VIG) share many of the blue-chip names you'll find in broad-market ETFs, that behavior is a bit contradictory -- until you realize that dividend stocks are hot, so any investment that focuses on them is likely to be successful.
Trying to time the market is notoriously difficult. Investor sentiment can sometimes act as a valid signal of things to come, while being more of a contrarian indicator at other times. The safest thing to do is to accept the market's ups and downs as part of your overall investing strategy, and then craft a financial plan that lets you stay comfortable even when the stock market gets choppy. Having that foundation beneath your strategy will help you fight off emotion and, in the end, lead to better results.
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