The Big Idea

Hot and cold funds, steady ETFs

| March 3, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Flows into and out of fixed income mutual funds tend to run hot and cold depending on the market—hot in bull markets for fixed income, cold in bear markets. But fixed income ETFs, on the other hand, seem largely immune to the cycles. The last few years have put those differences in sharp relief and show why the market in public fixed income total return is steadily becoming more passive.

Fixed income mutual funds have seen hefty swings in flows in recent years. More than $213 billion in assets left those funds in March 2020 as market values whipsawed (Exhibit 1). Then as the market rebounded from March 2020 and stabilized through end of 2021, a cumulative $685 billion in assets flowed back in. Flows reversed as the market fell in 2022, and fixed income mutual funds lost $393 billion in assets.

Exhibit 1: Volatile flows into fixed income mutual funds, steady flows into ETFs

Source: Investment Company Institute, Santander US Capital Markets

Fixed income ETFs, on the other hand, have clocked a steady average gain of nearly $15 billion in assets a month since the start of 2020, tallying nearly $560 billion since then. The steady trend in ETFs is in clear contrast to the ups and downs of active managers.

Work by Itay Goldstein and others at the University of Pennsylvania’s Wharton School shows investor redemptions from bond funds get heavier under a trifecta of circumstances:

  • As expected performance suffers,
  • When a fund portfolio holds relatively illiquid assets, or
  • When market liquidity gets worse.

Investors have incentives to exit a fund early under these circumstances or else risk getting stuck holding the least liquid and potentially least valuable assets. All three circumstances likely described market conditions in 2022 coincident with some of the most significant mutual fund redemptions in years.

Fixed income mutual funds seem somewhat unique in this exposure. An early run on a fund does not tend to happen for equity mutual funds because of that market’s deeper liquidity, Goldstein finds, although equity funds with illiquid positions show signs of the pattern. And it does not tend to happen for bond or equity ETFs since there is no redemption mechanism to create incentives for an investor run.

Returns to active fixed income funds changed in 2022 in concert with rising market volatility and heavier demand on fund liquidity. Among the 10 largest fixed income funds benchmarked to the Bloomberg US Aggregate Bond Index, which includes the AGG ETF, average returns weighted by AUM declined from 54 bp above the index in 2021 to 24 bp above the index in 2022 (Exhibit 2). But more striking, the unweighted standard deviation of returns relative to the index across the funds ballooned from 56 bp to 194 bp. The volatility of the market and the demands of managing fund liquidity likely magnified performance differences across funds.

Exhibit 2: Active fixed income fund performance became more volatile in 2022

Note: Funds identified on Bloomberg using the Bloomberg US Aggregate Bond Index as its primary benchmark. Returns based on historical fund analysis.
Source: Bloomberg, Santander US Capital Markets

Passive investing in public debt markets is likely to keep growing, with some pluses and minuses for markets. While a bigger ETF share could reduce the liquidity risks created in active funds, it may also reduce active policing of relative value. Creation and redemption of marginal ETF shares also could raise return correlation across index assets since buy and sell decisions get made at the portfolio rather than the security level. For debt issuers, more index investing could also create incentives for bigger issues eligible for inclusion in a benchmark.

Despite the gains in AUM for ETFs, active fixed income mutual funds still dominate the market for public total return management. Bond mutuals funds held $4.64 trillion in assets through January, according to the Investment Company Institute, while ETFs held $1.32 trillion. That likely means that the total return bid will likely continue repeating history: better buyers in bull markets, better sellers in bear.

* * *

The view in rates

OIS forward rates have become more hawkish than the Fed’s December 2022 dots, approaching 5.50% now by August this year and closing December 2023 at 5.39%. Persistent inflation, including the January month-over-month PCE core deflator—the Fed’s favorite measure—have persuaded the market that the Fed will keep raising rates. Just as the Fed has been predicting for months.

Fed RRP balances closed in the last few days at $2.19 trillion, up $50 billion from the start of the week. Despite apparent Fed expectations that attractive rates in money markets will draw funds away from the RRP, it clearly is not happening yet.


Settings on 3-month LIBOR have closed Friday at 499 bp, up 4 bp on the week. Setting on 3-month term SOFR closed Friday at 494 bp, up 5 bp on the week. The spread between these benchmarks is now as narrow as it has been in at least five years.

Further out the curve, the 2-year note opened Friday at 4.87%, in the neighborhood of fair if fed funds climb just above 5.0% and remain there into mid-2024. The 10-year note opened well above fundamental fair value at 4.02%, up 18 bp on the week.

The Treasury yield curve has finished its most recent session with 2s10s at -86 bp steeper by 1 bp over the last week. The 5s30s finished the most recent session at -33 bp, flatter by 5 bp over the last week. The 2s10s curve looks likely to invert by around 100 bp shortly before Fed tightening comes to an end. That should come by mid-year.

Breakeven 10-year inflation finished the week at 247 bp, up 10 bp in the last week. The 10-year real rate finished the week at 154 bp, down 3 bp in the last week.

The view in spreads

Volatility has move up modestly through February but still looks biased to trend down with each reading on inflation and employment and each Fed meeting. Each number and meeting should give more clarity to inflation, growth and Fed policy. Both nominal MBS and credit spreads should tighten as volatility drops. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields closed Friday at 158 bp, up 9 bp on the week. Par 30-year MBS TOAS has closed Friday at 53 bp, wider by 3 bp on the week.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. Leveraged and middle market balance sheets are vulnerable, especially with the sharp tightening of bank credit. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly.

Steven Abrahams
1 (646) 776-7864

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