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July 27, 2018

The Average Equity Fund Investor Remains Guarded, While APs Keep the Pedal to the Metal

by Tom Roseen.

With the U.S. equity markets once again reaching toward record highs this past week, supported by stellar Q2 2018 earnings and revenue reports, equity fund investors appeared to be more guarded than their authorized participant (AP) counterparts. The former were net redeemers of equity funds to the tune of $3.2 billion for the Thomson Reuters Lipper fund-flows week ended Wednesday, July 25, while the latter padded the coffers of equity ETFs (+$2.5 billion).

Before we continue, let’s first define what APs are. APs play a primary role in ETF liquidity and are the key participants of the ETF creation/redemption mechanism. APs are typically large institutional organizations, such as market makers or specialists, to whom an ETF sponsor hands off the responsibility for bundling or unbundling the underlying securities needed for creating or redeeming ETF shares. As such, they are the primary source of fund flows for ETFs. They have the exclusive ability to alter the supply of ETF shares in the market, and we monitor this practice to capture the net fund flows.

When investors buy and sell ETFs over an exchange, they directly impact volume for—not flows into or from—the exchange-traded product. In contrast, when conventional fund investors buy or sell shares of a mutual fund, they directly influence flows for the fund in question, leading the fund’s management company to create or destroy shares.

Distinguishing between mutual fund investors and ETF APs helps some analysts form opinions on the trends of the two fund groups’ behavior (one is retail in nature and the other institutional, each with its own unique goals).

For this past fund-flows week equity funds (including ETFs) witnessed a $620-million net redemption, but—as previously stated—that sum came from two disparate investment groups. Looking at the year-to-date figures, we see there have been two distinct trends occurring in the industry.

First, retail investors appear to be embracing nondomestic equity funds (ex ETFs), injecting some $61.1 billion YTD through July 25, but they were net redeemers of domestic equity funds, withdrawing a net $62.9 billion. This does not appear to be a result of performance chasing. The average U.S. diversified equity fund returned 6.96% year to date, while its world equity fund counterpart suffered a 0.65% decline for the same period.

Netting the flows for domestic and nondomestic equity funds, we see that retail investors are net redeemers of equity funds (-$1.9 billion) year to date. We can assume that some retail investors are just reallocating their portfolios to underrepresented asset classes, while others may be moving toward the lower-cost, tax-efficient benefits found in some ETFs.

In the second trend we note that APs are increasing the inventory of ETFs, perhaps in anticipation of a disintermediation of sorts from retail funds to ETFs. Year to date, APs have injected a net $39.2 billion into domestic equity funds and $12.3 billion into nondomestic equity funds.

Interestingly, despite hikes in the Federal Reserve’s key lending rate, year to date both fund investors (+$50.2 billion) and APs (+$42.2 billion) continue to pad the coffers of bond funds and ETFs. And, there doesn’t appear to be a preference for passively managed fixed income funds/ETFs versus their actively managed fixed income fund counterparts.

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