Breakout

ETFs: Big Winners This Year, But Dilemmas Ahead in 2013

Breakout

While fund flow numbers have been weak for the mutual fund industry this year, investors have poured money into exchange traded funds (ETFs), and are now positioning optimally for 2013.

According to ETFtrends.com, ETF assets are up 26% or $273 billion so far this year. This easily surpasses the $119 billion total seen in 2011 and is on track match the record set in 2008, according to Morningstar.

Despite more dollars in the space, there was a burst of smaller providers who "realized they can't keep products out there," says Todd Rosenbluth, developer of S&P Capital IQ ETF research and ranking methodology, which ranks 750 ETFs.

While there were 170 new ETFs and ETNs this year, there were 98 that closed as of December. In fact, so many failed that some dubbed it "The Year of the ETF Closure."

"There's been talk about closing ETFs, and that happens because some ideas don't stick," says Tom Lydon editor of ETFtrends.com, in the attached video. "But we continue to see net positive new ETFs in the marketplace."

Flows in 2012 were dominated by taxable bond ETFs, which have attracted a record $48 billion in inflows year-to-date, according to Morningstar. PIMCO Total Return ETF (BOND), the largest actively managed ETF and the most popular newcomer of 2012, has gained 10% since launching in February. With nearly $4 billion in assets already, Lydon predicts BOND will be dubbed "ETF launch of the year."

Heavy inflows to fixed income are likely to be a continuing trend in 2013 as investors hunt for yield with low cost structures, says S&P Capital IQ's Rosenbluth. Which corners do well will ultimately come down to risk tolerance -- whether money continues to flow heavily into high yield, for instance, depends naturally on the state of the economy. Investment grade bond ETFs -- which have a higher yield than Treasuries, but not that much more credit risk -- are likely to gain attention and are positioned to do well, he says.

What else is there to think about in 2013? Here are three more considerations:

Dividend Themed ETFs
The complete essence of dividend stocks has changed in the last few weeks as companies prepare for tax changes in 2013. A flood of special dividends has resulted as executives seek to reward shareholders, and themselves, before higher tax rates come into effect.

Related: Winners and 'Losers' of the Special-Dividend Bonanza

That could mean both a dearth of dividends in general, as so many were accelerated, in 2013, and a smaller profit after taxes on those that weren't.

"There's reason for people to be talking about it and concerned," says Rosenbluth,"but their appeal is still in relation to what the prospects are for the global yielding economy." These portfolios won't do as well if there's strong economic growth, and will have good downside protection and tend to do well in times of market uncertainty. "We think the market uncertainty is a greater issue than the [tax change]," he says.

The key is to look for a portfolio that owns stocks that are consistently and historically raising the dividend, he advises.

One example is WisdomTree DEFA (DWM), which owns stocks like China Mobile (CHL) and Novartis (NVS). Another is Vanguard Dividend Appreciation ETF (VIG), with stocks like Wal-Mart (WMT), Coca-Cola (KO) and (IBM). "Their decisions are unlikely to be changed," he says.

There were 18 dividend themed ETFs in the U.S. stock sector in 2012, and they were quite popular, with total assets around $45 billion, versus just $8 billion three years ago, notes Morningstar's Rawson.

Ways to Return to Risk
Rosenbluth predicts that in 2013 we'll see investors seek out more risk and they'll look to ETFs to do so. In this case, diversified international portfolios and emerging market products are likely to do well.

An example of the former would be WisdomTree DEFA (DWM), mentioned above, which has a diversified, dividend focused international portfolio focuses more on developed markets, like Japan, Australia and the UK.

As for the latter, S&P Capital IQ is also positive on a number of emerging market economies -- China, Mexico, Russia, Turkey -- and expects to see strong growth in ETFs that have exposure to those countries. For example, Rosenbluth points to iShares MSCI Emerging Markets Index (EEM), which focuses on various sectors and good growth-oriented stocks in diversified emerging markets like Korea, Brazil, China. It's up 15% in 2012.

Of course, the big caveat would be concerns about the global economic slowdown and the U.S. 'fiscal cliff.' Therein is the risk. If the 'cliff' situation isn't resolved, risk-on assets such as emerging markets are unlikely to do well.

How to Think About Yield
In an ideal world, the higher the yield, the greater the risk you're taking on from a duration perspective, or from a credit quality perspective. However, yields on various bond ETFs have come down to similar levels despite the fact that they have different durations, says Rosenbluth. Essentially, investors are taking on different duration risk, they're just not getting rewarded for it.

For instance, the Vanguard Intermediate-Term Bond ETF (BIV) has a yield of 1.7% and a duration of 6.5 years, while the Vanguard Total Bond Market ETF (BND) has a similar yield of 1.6%, with a duration of 5 years.

"You're taking on more duration risk in the immediate term, but the yields are quite similar, not what one would expect," says Rosenbluth. "The argument we're making is that people need to look beyond yield when they're making a fixed income ETF decision."

Similarly, if you're seeing a "high yield portfolio" that's not in proportion to others you've seen, "it could mean too much money has flowed in, so you're not getting the bang for your buck," he says.

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