Despite increased volatility last month, markets ended the first quarter on a high note. Some of the best ETFs and mutual funds surged in March, scoring double-digit returns for the quarter. The financial sector suffered as several banks collapsed. Value funds retreated.
The yield curve inverted further as short-term rates rose on the back of the Federal Reserve's tightening. An inverted yield curve usually indicates a coming recession. The 10-year U.S. Treasury yield closed at 3.48%, down about 40 basis points in March and the quarter.
"The Fed rate hike of 25 basis points was not a surprise but it was what most are calling a dovish hike," said Rich Weiss, chief investment officer of multi-asset strategies at American Century Investments. "There was verbiage around it which indicated that the Fed is nearing the end, if not possibly at the end, of the tightening cycle, which the stock market obviously ate up. It loves hearing that kind of news."
Best ETFs In The Green
Major indexes ended the month in the green, with the Nasdaq composite outpacing all others with a 6.78% return. It is up 17% this year. The S&P 500 and the Dow rose 3.67% and 1.89%, respectively, in March. They've gained 7.5% and 0.38% this year, respectively. International stocks continued to do well, with MSCI EAFE index advancing 7.5% year to date.
Despite the encouraging news, several areas of the market underperformed. U.S. diversified equity funds rose an average of just 0.11% in March, for a year-to-date return of 5.05%. Among the best mutual funds were large cap growth funds, up 6.51% and 13.52% for the month and the quarter, respectively. Other strong performers were multicap growth and S&P 500 index funds.
Small caps and value funds lagged. Small-cap value funds fell 6.71%, slashing their 2023 performance so far to just 0.77%. Midcap value funds also declined.
Several of the best diversified stock ETFs scored impressive returns. Top performers with 9%-plus returns in March included Invesco Nasdaq 100, Invesco QQQ Trust and Vanguard Mega Cap Growth. They're up around 20% this year.
Going Global
Internationally, top ETFs in March were Breakwave Dry Bulk Shipping, VanEck Vietnam and Invesco China Technology, all rose over 7% last month. Year to date, the best ETFs are iShares MSCI Mexico, Robo Global Robotics & Automation and WisdomTree Europe Hedged Equity, with 17%-plus returns.
"It's been an interesting quarter to say the least," said Matthew Bartolini, head of SPDR Americas Research at State Street Global Advisors. "We've seen a significant trepidation to deploy capital across the ETF landscape."
Stock and bond ETFs had $81 billion of inflows this quarter, wrote Bartolini in a report. This was 6% below the first quarter's historical 10-year average. The drag came primarily from very low inflows into equity ETFs: just $29 billion which was 47% below the first quarter's 10-year average.
Bonds, on the other hand, did quite well, representing 61% of total inflows in the first quarter. The beneficiaries of the capital flow were government bond funds such as ultrashort funds. They "took in their third-most ever for a month (+$16 billion) and fourth-most for any three-month period (+$27 billion)," he wrote. "Bond ETFs took in $53 billion, 114% above their historical 10-year average for a first quarter."
Best ETFs For Bonds
Among the best ETFs for bonds was Quadratic Interest Rate Volatility and Inflation Hedge, up 9% in March and 1.41% this year. Other top performers included Simplify Short Term Treasury Futures Strategy and Vanguard Extended Duration Treasury, both up over 6% in March.
General domestic taxable bond mutual funds rose an average of 1.11% and 2.72% in March and the first quarter. Top performers included general U.S. Treasury, general U.S. government, as well as corporate debt A and BBB-rated funds, all up between 2.5% and 3.6% in March. They're up between 2.8% and 4.4% this year.
International bond funds also did well. Emerging markets local currency debt funds soared 3.68% in March, for a yearly advance of 4.48%. International income funds added 2% for both periods.
Follow The Flows
The reshuffling of the asset classes during the quarter was not just out of U.S. equities and into bonds, but also into foreign stocks.
"While U.S. equity funds had well-below-average flows this past quarter, non-U.S. exposures saw flows 27% above their historical (first quarter) figure," Bartolini wrote. "In fact, regional funds, led by ETFs focused on Europe, posted their ninth-best flows for any three-month period ever this quarter."
In the U.S., mostly cyclical and defensive sectors saw outflows in March and in the first quarter. Health care, utilities and consumer staples saw $4 billion in outflows. Another $5 billion left the energy sector. Dividend and quality ETFs, on the other hand, experienced continued record inflows, according to the report.
"There is an increase in relative positioning for non-U.S. equity exposure," said Bartolini. "So, what did investors do this quarter? They bought bonds, they sold U.S. stocks and they bought non-U.S. stocks."
What's Next For Best ETFs?
American Century's Weiss believes the economy is "almost certainly going to go into a recession this year, and likely a more serious downturn than previously thought. It will be sooner than most people thought."
He cited a perfect storm of tighter lending standards, housing and manufacturing slowdown, earnings decreases and elevated inflation. "These indicators aren't mild, they're pretty severe," he said.
As such, he's underweight equities in general, but favorable toward non-U.S. equities. He continues to underweight pro-cyclical, growth-oriented sectors, such as tech and telecom. He prefers the more defensive, value-oriented sectors, and is underweight real estate investment trusts.
"We don't believe that equities are pricing in a recession," he said. "Equities seem to be pricing in perhaps a mild slowdown, but not necessarily a recession, so we think there's more downside here to come in equities."
Keep Cash Ready
Weiss said it's a good idea to keep some dry powder for when "the last shoe drops," meaning when the labor market finally starts to deteriorate more significantly. "That's when the buying opportunities will present themselves," he said.
The good news is that investors can get handsome yields today by just putting their money into short-term bond instruments. For example, the SPDR Bloomberg 1-3 month T-bill ETF sports an SEC yield of 4.52% for an investment into short-term U.S. Treasuries, which carry almost no risk. The $29.7 billion fund is up 1% this year and charges an annual fee of 0.135%.
"The stock market is expensive," said Mike Kagan, co-manager of $6.8 billion ClearBridge Appreciation Fund (SHAPX). Despite last year's declines, "the market is still around the 90th percentile of historical valuation measures. And so the combination of a likely recession and an expensive market is not a pretty outlook for market returns over the next year."
Tread Carefully With Best ETFs And Mutual Funds
He advises investors to be careful. "I'm an equity manager, but I think bonds are more attractive than equities here. I think rates fall from here, so you get nice returns on bonds," he said.
That said, for investors who are looking to invest in stocks, he recommends to look for those with yields and those with defensive business models. For example, his fund holds discount retailer TJX Companies and ASML Holding, a leading supplier of photolithography equipment to the semiconductor industry and an IBD Big Cap 20 member.
SHAPX is up 4.5% this year. It carries an annual fee of 0.93% and a front load of 5.5%.
Kagan says that because the consumer and the economy are still relatively strong, and the unemployment low, he doesn't expect the same kind of destruction to happen as in 2008.
However, "You need to be careful about what you own right now. Be wary of companies that don't have earnings and don't have cash flow," he added. "And think about having some bonds in your portfolio. If you don't, it's a good time to own them."
