March 3, 2018 – 6:00AM EST by John Waggoner
When investor demand meets a hot market — as international ETFs are experiencing today — you’d expect the industry to roll out new products like a World War II assembly line.
While that hasn’t happened yet, the rally in international stocks is still young, and fund companies are gearing up for wartime production. Advisers can expect innovative exchange-traded funds to come their way this year, but will those funds be worth considering for client portfolios?
Despite the ripsnorting bull market in the U.S., investors have yanked a net $198 billion from domestic stock funds since the start of 2010, the first year the Investment Company Institute began reporting combined ETF and mutual fund flows. At the same time, investors have poured $1 trillion into international stock funds.
Of the combined $3.8 trillion in international ETFs and mutual funds today, just $863 billion is in ETFs — so there’s plenty of room for ETFs to catch up. And looking at flows over the past year, it seems they eventually will.
In the 12 months ended Jan. 31, of the approximately $279 billion flowing into international stock funds, $185 billion went into ETFs versus $94 billion into mutual funds, according to ICI.
$279 TotalDomestic stock fundsInternational stock funds
Who is pushing all that money into international ETFs? You guessed it: financial advisers. Most money that moves into ETFs does so with an adviser at the helm, and the flow is likely to quicken this year.
The InvestmentNews 2018 Outlook survey of 344 advisers in December found that while only 12% of financial advisers plan to increase allocations to U.S. equities this year, 45% plan to raise allocations to international equities. Advisers also said they have an average of 31% of client assets in exchange-traded funds, and 29% plan to add more to that in the area of international equity in 2018 (27% also pointed specifically to emerging markets).
“We have been increasing international exposure for the past two to four years based on a client’s situation,” said Aaron Clarke, financial adviser at Acorn Financial Services. “Our offices manage over $800 million in assets, and most clients have at least 50% of their equity exposure in international investments.”
Higher returns from overseas in the past 12 months will only encourage more flows to international ETFs. After a decade of lousy performance, the Europe, Australasia and Far East index (EAFE) woke up over the year, gaining 18.3% through Feb. 27, versus the S&P 500 index’s 18.1%. Furthermore, most foreign markets are cheaper, relative to earnings, than those in the U.S.
“We have increased our international exposure this year and last year to both developed international and emerging-markets international,” said Sterling Neblett, founding partner of Centurion Wealth Management. “We feel that international equities are currently selling at cheaper valuations than domestic equities. Another interesting fact is that they still have not reached their 2007 pre-financial-crisis peak levels yet.”
While the ETF industry has spawned hundreds of variants on domestic stocks, it has produced fewer international options. Currently there are 494 international stock ETFs, compared to 816 domestic stock ETFs, including sector funds. The five largest international exchange-traded funds account for 57% of total international ETF assets.
“Most of those various flavors of vanilla have been on the menu for a long time,” said Ben Johnson, director of global ETF research at Morningstar Inc.
But that’s changing. For example, the industry has rolled out 25 international strategic beta ETFs in the past 12 months. (Strategic beta funds, also known by the moniker “smart beta,” use hedge-fund strategies to either increase returns or reduce risk.)