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Oct. 6, 2022, 3:56 p.m. EDT

ETF investors grapple with ‘manic depressive’ stock market after September flows signaled ‘risk-off bias’

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By Christine Idzelis

Hello! ETF flows were “resilient” in September, but have you looked beneath the surface? Citi saw “a clear risk-off bias.” Markets have been volatile as there’s “deep lack of conviction” as investors cope with Fed-related anxiety, the chairman of Davis Advisors tells MarketWatch in this week’s ETF Wrap.

Please send feedback and tips to christine.idzelis@marketwatch.com. You can also follow me on Twitter at  @cidzelis  and find me on  LinkedIn .

Money has kept flowing into exchange-traded funds despite a rocky September, but there were signs of wariness as investors continue to grapple with big swings in markets and anxiety over the Federal Reserve’s aggressive monetary tightening.

There’s been “a manic depressive quality” to the stock market, said Chris Davis, chairman of Davis Advisors, in a phone interview. “You have this dramatic oversteering” both up and down. 

That’s because many investors harbor a “deep lack of conviction” about the direction of equities, focusing on weekly data that has stoked hopes and fears about the market and the economy, according to Davis. He also pointed to “enormously bearish” sentiment among investors as the Fed aggressively hikes interest rates, after holding them unnaturally near zero.

“What we are starting to see is actually a return to normalcy – an unwinding of a massive distortion,” said Davis. “What has terrified the market is a huge reversal.” 

While ETF flows remained “resilient” in September, a look beneath the surface reveals that “a clear risk-off bias persisted last month across not just equities, but fixed income as well,” according to a research note from Citigroup on Oct. 4. 

“ETF investors were not high conviction buyers as flows continued to focus on low volatility exposures within each asset class,” Citi analysts said in the note. “September flows followed the enduring year-to-date trend of cautious allocations .”

US-listed ETFs attracted $23.5 billion in net new assets last month, with U.S. equity funds leading inflows, according to the note. U.S. equity ETFs saw $15.5 billion of net inflows, followed by fixed income with $11.4 billion, the report shows. 

But “strong U.S. equity trading ETF inflows may be misread,” warned the Citi analysts. “A spike in shares outstanding could be a sign of continued short demand.”

Investors who short securities are wagering that they will decline. 

Citi considered that “capital markets and options dynamics” are influencing flows of heavily traded U.S. equity ETFs. Short interest has risen in such funds, the analysts said. While these funds had large inflows in September, “we doubt it was potential dip buying,” they wrote. “Instead, we suspect it was further hedging.”

‘Sentiment overshoots’

Citi this month lowered its year-end target for the S&P 500 /zigman2/quotes/210599714/realtime SPX +0.80% by 200 points to 4,000, which is above current trading levels. 

After large back-to-back gains this week, the S&P 500 slipped 0.2% Wednesday to close at 3,783.28. The index had tumbled 9.3% in September for it biggest monthly percentage drop since March 2020, when U.S. stocks tanked on COVID-19 fears.

The SPDR S&P 500 ETF Trust /zigman2/quotes/209901640/composite SPY +0.76% was down 1.1 % Thursday afternoon, bringing its decline so far this year to more than 21%, FactSet data show, at last check. 

“Sentiment overshoots that have priced in recession risk serve as a basis for our near-term risk-on rally call,” the Citi analysts said. 

Read: The stock market is wrong: the economy isn’t going to ‘blow a gasket’ just yet, warns economist

Meanwhile, ETF investors’ persistent preference for low risk aligns well with the weak sentiment readings Citi is seeing in its broader U.S. equity strategy research, according to its note on Oct. 4.

Bearishness has been building despite US-listed ETFs in September seeing “another solid month of new asset gathering,” with details beneath the surface of last month’s flows indicating that investors were “clearly reluctant buyers of ‘risk,’” according to the Citi analysts.

“Flows skewed to lower volatility exposures across asset classes,” they wrote. “This mirrors the trend that has been in place all year.” 

ETF investors historically have been “more eager to put money to work than other investor bases,” according to Citi.

In equities, the flow bias this year has been towards strategies with low volatility and involving dividends, the analysts said. “Investors have shied away from more volatile exposures,” such as smaller-caps, “generally unprofitable themes” and some single-country, emerging market strategies, their research found. 

Meanwhile, stock market volatility has risen recently, with the CBOE Volatility Index trading around 30 Thursday afternoon, according to FactSet data. 

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