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A Bond Rotation Could Support Stock ETFs

With prospects of a Federal Reserve interest rate hike sometime this year, stock exchange traded funds could find support from a potential great rotation out of bonds.

Asset management consultancy firm Create found that among 705 institutional investors, including pension funds, sovereign wealth funds, asset managers and investment consults with combined assets of $27 trillion, about a third of respondents expect investors to significantly raise exposure to equities over the next three years, whereas 16% disagree, reports Madison Marriage for the Financial Times.

“To be risk averse is the biggest risk [investors] face,” Amin Rajan, chief executive of Create, said in the FT article. “Investing in an era of negative real yields is like driving a car backwards. [Quantitative easing] has pushed all investor groups up the risk curve — whether they like it or not.”

Many believe the rotation will be particularly evident among defined benefit pension schemes where managers will move to equities to meet rising liabilities, deficits and negative cash flows. Defined contribution plans and retail investors will also favor risk and add greater equity exposure as well. [Retirees Should Think About Augmenting Yields with Dividend ETFs]

“Prudence has held that retirees or near-retirees should be overweight in bonds and not take risks with their retirement nest eggs,” Rajan added. “The prospect of ultra-low yields for the foreseeable future is sidelining this age-old wisdom. In search of yield, investors are now forced to act contrarian.”

Over two-thirds of investors anticipate current equity valuations to be sustained, even though broad stock indices have hit all-time highs. Additionally, about 47% of investors expect a rotation from bonds into equities after overweighting fixed-income assets since the financial crisis.

“[Pension schemes] are underfunded so they need returns to go back to a more conservative level, which is why they are willing to add more to equities,” Alain Kerneis, head of client solutions strategy at BlackRock, said in the article.

ETF investors are already increasing their equity allocation, compared to fixed-income positions, this year. Over the first five months of the year, stock ETFs attracted $51.0 billion in net inflows while bond ETFs brought in $23.2 billion, according to BlackRock. In contrast, stock ETFs only added $22.4 billion in the first five months of 2014 while bond ETFs saw $26.0 billion in inflows.

Investors have already begun moving out of popular bond ETFs this year. For instance, the iShares 20+ Year Treasury Bond ETF (TLT) saw $1.87 billion in outflows year-to-date, according to ETF.com.

Some are even hedging bets against falling interest rates with inverse bond ETFs. For instance, the ProShares UltraShort 20+ Year Treasury (TBT) saw $83.9 million in inflows so far this year, Direxion Daily 20-Year Treasury Bear 3X (TMV) attracted $204.4 million and ProShares Short 20+ Year Treasury (TBF) brought in $36.5 million.

Meanwhile, investors have been turning to international equities this year. Led by the WisdomTree Europe Hedged Equity Fund (HEDJ) and the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF) , four of this year’s top 10 asset-gathering ETFs are currency hedged funds. The other two are the WisdomTree Japan Hedged Equity Fund (DXJ) and the iShares Currency Hedged MSCI EAFE ETF (HEFA) . Year-to-date, HEDJ added $13.9 billion, DBEF attracted $10.6 billion, DXJ saw $4.2 billion in inflows and HEFA brought in $2.6 billion. [Momentum for Currency Hedged ETFs]

For more information on the ETF industry, visit our current affairs category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.