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This year, 2023, will be important for the exchange traded fund (ETF) industry – it marks the 30th year since the first ETF was introduced to the U.S. market – and there is no reason to believe the rise in popularity of these assets among advisors will cease anytime soon. For instance, 2022 was a rocky year for performance across almost every sector of the market, and yet ETFs clocked their second-best year of inflows on record, raking in about $600 billion. While this paled in comparison to 2021 inflows, which reached approximately $900 billion by year end, this strong activity in ETFs bodes well for the continued health of these assets in the year to come.
Despite challenging economic headwinds, some industry experts anticipate that 2023 could be the year that ETFs cross the $1 trillion threshold for inflows. However, with so many different products available, advisors need to better understand some of the key emerging trends that will drive performance in the next year as they consider making changes to investment strategies and portfolios.
Below are the top three trends in 2023:
1. Green is “in” – ESG will continue to be a priority: ESG came under a microscope in 2022, as the SEC clamped down on greenwashing; it plans to enhance the regulatory framework that governs these types of funds. Plus the asset class underperformed during the market’s volatile year. However, a lot of the ESG funds that underperformed in 2022 were more tech-focused than pure play-products (i.e. “growth funds” that have assets in software, semiconductor, or internet stocks) as rising interest rates, inflationary concerns and the possibility of a U.S. recession continued to drag the technology sector.
As scrutiny around this fund category continues to heighten in 2023, ETFs that are more pure-play impact investments should continue to be of interest to investors. Governing bodies around the world continue to implement policies to reduce carbon emissions to combat climate change. That said, funds that focus on things like the carbon markets, the clean energy transition and improved food production will likely continue to gain traction among value-based investors over the long term. This can, as in the case of carbon-allowances futures funds, offer investors exposure to markets that aren’t otherwise accessible.
Supporting this idea is a recent report by PwC on ETFs, which found that “45% of ETF issuers expect 50% of their new launches to be ESG-focused,” indicating issuers will be responding to increased investor demand for these products in the year ahead and beyond.
2. Thematic ETFs aren’t just fads – this asset class has long-term staying power: Thematic ETFs have gotten a bad rap for being fad investments, focusing too much on niche trends that can easily, and often times quickly, fall out of favor with investors. But the market has typically embraced innovation, and a focus on customer choice in emerging asset classes can have real staying power if you know what you are looking for. Thematics are a retrenchment strategy – people aren’t betting on the broader market given headwinds that are creating market turmoil (like inflation, rising interest rates, fears about a recession, etc.). Instead, they are seeking spots of outperformance to generate more yield. Thematics are an extension of that. Research from PwC’s ETF report reached a similar conclusion, finding that thematic strategies will continue to be in demand by investors for the next two to three years. Some sectors that could be of interest in 2023 include clean energy, electric vehicles, infrastructure, robotics, and cybersecurity.
3. Keep an eye on actively managed funds – they are not all created equal: Actively managed ETFs are having a moment. According to NYSE data, more than 55% of all ETF launches in 2022 were actively managed, and 639 active ETFs experienced positive cash flows, representing nearly 71% of all ETFs. Actively managed strategies will likely continue to be of interest in 2023. Active managers usually perform better than their benchmarks in periods of volatility. If you take this collective wisdom and couple it with the notion that we have been in a historically volatile environment since 2022 – the second most volatile year on record –actively managed products and strategies are particularly relevant now. These investment vehicles are likely to be of interest to investors and demand will continue. PwC reinforced this theory in its ETF report, stating that actively managed strategies stand out as potential sources of demand and untapped opportunities as investors seek out these products over the next two to three years.
And while active strategies do have their benefits in a down market – particularly the ability to be nimble and make changes to holdings based on market trends and conditions – not all funds are created equal. Investors and their advisors must do their homework before adding these types of ETFs to a portfolio. There are certain funds that may be better positioned for active strategies. One example are funds that roll futures, which is a complex, nuanced and time-consuming investment strategy that requires an experienced portfolio manager. Therefore, conducting a thorough investigation of a portfolio manager’s past performance history, and the underlying strategy of the active fund you are looking to invest in, is essential.
ETFs have become the shining star among retail investors since the first product began trading in the U.S. in 1993. Interest in these versatile, cost-effective assets will not wane in 2023, even if market fundamentals continue to be shaky due to increasing inflationary concerns, global geopolitical factors, and rising interest rates. There remains a lot of room for growth in the ETF space, both globally and in the U.S. specifically, and investors could continue to convert funds from traditional mutual funds to ETFs this year as they did in 2022 (more than $42 billion in ETF assets were rolled over from mutual funds last year). But, as always, advisors need to ensure that the asset classes and products they are adding to a portfolio align with investment goals and risk tolerances before jumping headfirst into the welcoming waters of ETF investing.
Tim Collins is the president of Carbon Fund Advisors Inc., which is the fund sponsor of the Carbon Strategy ETF (NYSE: KARB).
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