Stock markets succumbed to increased volatility, rising inflation and climbing rates, posting the steepest declines since the Covid-19-induced losses of March 2020. Many of the best mutual funds and ETFs gave up some of their third-quarter gains and then some, despite seeing continued inflow in the first part of the month.
An uneven economic recovery, jitters over China’s real estate group Evergrande, and debt ceiling uncertainty didn’t help, pushing the stock market into a correction.
The 10-year U.S. Treasury yield rose more than 20 basis points during the month, ending September at 1.52%. Fixed income markets suffered on the whole. The sentiment was clearly risk off.
“Equity markets had their worst month since March of 2020,” said Chris Huemmer, senior investment strategist at FlexShares ETFs. “We broke the winning streak that we had for seven months of the equity market returns in the U.S.”
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The Nasdaq composite was the worst performer on the month, sinking 5.27%, while the S&P 500 shed 4.51% and the Dow declined 4.29%, according to Lipper Inc. data.
U.S. diversified equity funds lost an average of 3.77% in September, erasing their Q3 gains and leaving them down 0.9354% on the quarter. Only a few sectors were spared from the carnage. The best mutual funds and ETFs struggled to retain their earlier gains. Among the worst performers were equity leverage and specialty diversified equity mutual funds, while those that saw the smallest declines were small-cap value and mid-cap value funds, down only 1.49% and 2.99% on the month, respectively. Year to date, the best mutual funds remain small-cap value and midcap value funds, each up 25.51% and 20.29%.
The global picture wasn’t much better, with most international and emerging funds posting sharp declines. Japanese and India region funds were the only ones to show positive returns. India funds are the best mutual funds for the year, topping 25%.
Despite the widely negative performance, September still saw positive flows, mostly realized in the first half of the month. About $32 billion went into equity ETFs, while $14 billion flowed to fixed income, according to Bloomberg Finance and State Street Global Advisors. It was the slowest month of the year for U.S. equity ETFs, however, even though they saw a record $300 billion in inflows this year.
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September being the slowest month of the year “is really signaling that there was a risk-off sentiment throughout the month, but certainly in the second half,” said Matt Camuso, ETF strategist at BNY Mellon Investment Management. “Although it’s a slow month, if we look more broadly, ETFs are still having a record year in 2021, at roughly $630 billion year to date.”
Among the best U.S. diversified stock ETFs for the year were Invesco S&P SmallCap Value with Momentum (XSVM) and Invesco S&P SmallCap 600 Revenue (RWJ), up 45%. They posted only slightly negative returns for the month.
Within sectors, energy ETFs held the spotlight. First Trust Natural Gas (FCG), Invesco Dynamic Energy Exploration and Production (PXE) and North Shore Global Uranium Mining (URNM) held the top three spots for the month and the year. They were up between 18% and 21% in September, and more than 79% YTD.
Going forward, Camuso said the best mutual funds and ETFs are trying to understand how long this “transitory inflation” will last and “at what point do we call this an inflationary perspective.”
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He noted that the Fed is definitely more hawkish but also have a “continued confidence in the economic recovery, although being slowed by the virus. But we do expect them to start tapering asset purchases this year, in November or December.”
Camuso also pointed out that the market gives a 75% chance for the Fed to start hiking rates in the second half of 2022. And the markets are still experiencing supply chain issues, which adds to inflationary pressures.
In this context, he favors equities over fixed income, with an emphasis on quality. Financial sectors and U.S. REITs should also benefit from rising rates.
Bullish On Europe, Natural Resources
FlexShares’ Huemmer is still optimistic on global growth, even though it’s moderating. He’s bullish on risk assets in developed markets, especially ex-U.S.
“The ex-U.S. side is interesting because their recovery is slightly behind what we’ve seen here in the U.S.,” he said. “There’s probably more room to run. The valuations are attractive compared to the U.S. And I’ve also seen rates in Europe tick higher. So, all of these are positives that there’s potential for less of moderation in growth in Europe and in developed markets than what you’re seeing in the U.S.”
He’s also bullish on natural resource equities, due to the continuing supply chain issues and increased demand. With moderating growth and increased volatility, he stresses the need to focus on high-quality companies — those that are the most financially well positioned — as well as those that offer lower volatility.
Nevertheless, he advises investors to remain sector-neutral and not take on large overweight positions: “As interest rates shift, you don’t want to be overweight utilities.”
FlexShares U.S. Quality Low Vol (QLV) invests in companies that showcase strong management efficiency, profitability and cash flow. The fund also applies low-volatility screens and a quality tilt. The $146 million fund is up 11.4% YTD and charges an annual fee of 0.22%. Its ex-U.S. equivalent is the $82 million FlexShares Developed Markets ex-U.S. Quality Low Volatility (QLVD). The fund is up 4.24% YTD and charges 0.32% per year in fees.
Fixed Income Funds Faced Choppy Market In September
Fixed income markets also experienced a choppy September as rates rose. General domestic taxable bond funds declined 0.33% on average, trimming their Q3 and YTD return to 0.44% and 2%, respectively. High yield and loan participation funds, along with a few short-term U.S. Treasury funds, were the only funds that ended the month in the green.
“The market is currently grappling with two things,” said Chris Brown, co-manager of the $640 million T. Rowe Price Total Return (PTTFX). “On one hand, you’ve got a Fed that’s clearly past the point of peak accommodation back in May. And then in June we had the actual FOMC meeting which was quite definitively hawkish.”
He said this came at a challenging time: “You had very hot inflation readings, but at the same time you had labor market readings which were not as hot.” With the hawkish Fed combined, “that’s when the volatility started (in the summer). And I think that fed into September as well.” In addition, the September FOMC meeting was also hawkish.
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On the other hand, he noted, the market is grappling with a more dovish long-term outlook and future rate hikes that might not be as fast paced as they usually are in times of inflation.
“The endgame in terms of the terminal rate is well below what would historically be thought of as neutral,” he added.
Here too, Brown favors quality. This means shorter-term, higher-quality government bonds in the U.S., Canada and Europe. He finds the risk-reward in the credit sectors, such as investment grade and high yield bonds, too low for the moment.
Treasury inflation-protected securities (TIPS) could still provide some value through the end of the year, but he believes that inflation is transitory and will calm down in 2022. Other areas he’s positive on are bank loans, collateralized loan obligations (CLOs) and short-duration agency mortgages. Emerging markets are under pressure due to a stronger dollar.
“Stay the course in bonds,” he concluded. “I believe it will continue to be a ballast in the portfolio. There will be times when rates will go up, just like times when stock markets go down, but long term, the ballast-like characteristics of the bond market will endure.”
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