Matt Tucker: In my last blog, I recapped 2011 and how it turned out to be the year of unmet investor expectations. Instead of interest rates rising, they fell. Instead of the municipal bond market suffering from widespread defaults, it fared better than in 2010.

So, how did the flow of events influence the flow of funds in 2011? How did investors use fixed income ETFs to implement strategic and tactical views based on those events? Let’s take a look.

At the beginning of the year, most investors were convinced that interest rates were going to rise. To hedge rising rates in the first three quarters of the year, investors turned to short duration ETFs. They also relied on leveraged and inverse ETFs, with these types of funds almost doubling in size by September¹.

But interest rates defied expectations and fell throughout the year, especially after the Federal Reserve made it clear that it would keep short term interest rates low until 2013. That prompted many leveraged and inverse fund investors to capitulate in the fourth quarter and redeem their holdings¹.

For many investors looking to adjust interest rate risk, long duration Treasury ETFs also became a vehicle of choice. For example, trading volumes of iShares Barclays 20+ Treasury Bond Fund (NYSEARCA:TLT) averaged $1.1 billion in 2011, reaching a maximum of $4.9 billion in mid-August¹. We’ve noticed that many asset managers and pension plans are using Treasury ETFs to gain exposure to rates

At the start of the year, US fixed income market flows indicated that investors were very concerned about the possibility of massive defaults in municipal bonds. Municipal bond investors pulled more than $17 billion from mutual funds this year through November 22.² At the same time, they added more than $580 million to municipal bond ETFs¹. While a few high profile defaults and bankruptcies were announced, wide-scale municipal defaults never materialized.

In addition to the surprising developments in the Treasury and municipal markets, 2011 was also marked by elevated volatility and political uncertainty. This volatility had a direct impact on asset flows, especially in riskier markets like high yield.

The chart below shows the rolling four-week inflows of the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA:HYG) versus the Chicago Board Options Exchange Market Volatility index (VIX) index, which measures the implied volatility of S&P 500 index options.

Spikes in the VIX index were associated with outflows in high yield bond ETFs, most noticeably starting in May 2011.

Source: BlackRock and Bloomberg as of 11/30/2011

Overall this year, total assets under management in US fixed income ETFs grew by $41.3 billion to $177.8 billion. Net new inflows accounted for about $40.7 billion of the total growth in assets, equating to a 29% growth in assets under management in 2011¹. In contrast, fixed income mutual funds gained $127.8 billion bringing total AUM to $2.9 trillion. That was a 4.8% increase over the year².

Stayed tuned for a future blog post where I outline my expectations for how I expect the ETF landscape to evolve in 2012.

Footnotes:
1 Source: BlackRock and Bloomberg as of 11/30/2011
2 Source: Investment Company Institute: Estimated Long-Term Mutual Fund Flows report data as of 11/22/2011

Bonds and bond funds will decrease in value as interest rates rise. A portion of the Fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.

Written By Matthew Tucker From The iShares Blog

Matthew Tucker has spent the past 16 years focused on fixed income analytics, portfolio management and strategy. As managing director of U.S. fixed income strategy at BlackRock, Inc., and a member of the Fixed Income Portfolio Management team, Mr. Tucker leads both product strategy for ETFs and North America and Latin America iShares strategies, as well as product delivery and client sales. He previously worked with Barclays Global Investors before it merged with BlackRock, and he led the U.S. Fixed Income Investment Solutions team responsible for overseeing product strategy for active, index, enhanced index, iShares and long/short products. Mr. Tucker was also a portfolio manager and a trader in fixed income focused on U.S. government securities.

He began his career at Barra, where he supported clients using the company’s fixed income analytics. Mr. Tucker holds a bachelor of business administration degree from the University of California, Berkeley, and is a Chartered Financial Analyst charterholder.

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