ETF inflows 50/50 between equity and fixed-income in 2023: Strategist

Investors seek out certainty in an uncertain market alongside heavy speculation over the Fed's year-end interest rate outlook. VettaFi Vice Chairman Tom Lydon joins Yahoo Finance's Rachelle Akuffo to detail his ETF picks to circumvent interest rate concerns, while also differentiating active and passive ETFs.

"Even though today there's $6.2 trillion in money market funds getting about 5%, when [interest] rates cut, that yield is going to be cut dramatically," Lydon details the overhang the Fed's interest rate strategy could have. "And they don't want to be stuck on the sidelines, they'd rather be longer duration — areas like corporate credit, even high-yield."

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Video Transcript

RACHELLE AKUFFO: Now as the Fed readies yet another rate decision amid its battle to tame inflation, investors ponder the next steps for their portfolio. As dominance in the Magnificent Seven stocks, and their impact on major indices, has waned throughout the year, and fixed income ETF appeal continues to grow, investors are looking out for strategies to stay on top of such an uncertain market. As part of our ETF report sponsored by Invesco Q Q Q, let's bring in VettaFi vice chairman Tom Lydon to get his insights on how you can be investing, and getting the most out of this uncertainty.

Good to have you back on the show here. So help us break this down. In terms of the flows that you're seeing, in terms of ETFs versus some of these equity markets, what is-- what are the data telling us?

TOM LYDON: Yeah. Great to be here, Rachelle. I'll tell you. Usually, you see about 1/5 of the money flowing into fixed income ETFs versus equity ETFs.

But this year, it's been almost 50/50. And part of that is, as we're surveying financial advisors all the time, most feel that a year from now, rates will be lower than they are today, that the Fed has applied its medicine. We'll probably have some type of recession, albeit a soft landing. But as we know, the Fed acts quickly in times of recession.

It's not 25 basis points every couple of months. They'll come in with a hatchet and start slashing rates to a great degree. And even though today, they're $6.2 trillion in money market funds, getting about 5%.

When rates cut, that yield is going to be cut dramatically. And they don't want to be stuck on the sidelines. They'd rather be longer duration.

So areas like corporate credit. Even high yield, as one of your earlier guests pointed out. Those yields are pretty attractive these days.

And we're starting to see more and more money go into corporate credit, high yield ETFs, with the idea that if they can lock those rates in for a longer period of time. And if they can be there during the period when rates get cut, they're not only getting the yield. But they're getting some appreciation as well.

RACHELLE AKUFFO: So Tom, with that in mind, then, walk us through some of your top picks for ETFs at the moment.

TOM LYDON: Well, a couple of things. We've stepped aside from the Magnificent Seven because people are scared of the volatility and the pricing. But if you look at RSP, the Invesco S&P 500 equal weight ETF, that's a 1/500 allocation to each of the 500 stocks. So you don't have that huge overweighting, and just 10 or seven stocks. That's also important.

The IWM, which is the Russell 2000 ETF. The valuations in the small caps today are cheap compared to large cap. You can get a PE of 10, as opposed to a PE of 20 in the S&P 500. But some of the alternatives that we've also seen have been covered call strategies.

One of the most popular has been the JP Morgan Equity Premium Income, which is JEPI. J-E-P-I. The yield there is almost 1% a month. 1% a month, while you're actually waiting for the markets to recover.

A complementary strategy is a Global X NASDAQ 100. Also 11.7% yield right now, where you're getting a stupendous yield, and you're also hedging your equity positions too. So those have been some of the standouts.

Along with quality stocks, the final one is the iShares quality factor QUAL ETF. Almost $10 billion have gone into that ETF so far this year. So the word is diversify outside the cap-weighted S&P 500 because that's where the value is. And that's where the diversification is.

RACHELLE AKUFFO: And Tom, I want to ask you about active versus passive ETFs, because some people, A, might not understand the difference. And they might not really understand the flows that are going into them at the moment. Where is that money flowing?

TOM LYDON: Well, you're right, Rachelle. ETFs were built on the back of indexes 30 years ago. S&P 500, the Russell 2000, the Dow Jones Industrials.

However, new ETFs have come out that have actually had active strategies. But still today, only 4% of the $7 trillion in ETFs is in active strategies. However, just last month, there was more money that went into active strategies than passive index-based strategies. And for the reasons we kind of touched on, if you're going to buy fixed income, you don't want to buy an index because, guess what? Some of those corporations may have debt that may be subject to default, or might be downgraded.

So dancing around the different issues is going to be important for active strategies. And then, as far as equities are concerned, buying companies that may be a big part of indexes. But might be too volatile, might be too expensive. Active managers can come in and not only select what they feel are the right companies. But also, the right waiting for their certain portfolio within that ETF strategy.

So active is surely back, where we had about 10 years coming out of the financial crisis where it was all passive strategies. The pendulum has swung. And we're seeing more and more active managers come and offer their mutual fund active strategies in an ETF form. It's about more choice.

RACHELLE AKUFFO: Most definitely important. Do your due diligence. And, of course, know your risk, as you're looking at some of these ETF selections. Appreciate you joining me this morning VettaFi vice chairman Tom Lydon. Thank you so much.

TOM LYDON: Thanks, Rachelle.