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Demand soars for risk-off ETFs

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The incredible level of market volatility arising from the uncertainty over the UK's referendum vote has caused a great deal of de-risking on the part of investors over recent months.

Chanchal Samadder (pictured), Head of UK and Ireland ETF sales at Lyxor Asset Management says: "The flows we saw last year and at the beginning of this year were into risk assets, equities across the board geographically but now we are experiencing a reversal towards a risk-off downside protection type of environment."

Risk-off has been dominated by fixed income, with investment grade credit in the US proving itself popular with investors over the last three months. "It's not just the referendum, but also the elections in Spain and everyone is closely watching the Fed as well which is bringing out a defensive position in the investors. Money continues to flow into ETFs but we have seen it in favour of more defensive assets."

The securities of choice are investment grade corporate bonds and government bonds even though many are under water. "It is a reflection of the investor mood that they are willing to pay someone to hold their money," Samadder says. "The US has been a favoured destination because it offers slightly better yields than the rest of the developed world."

Another indication of this risk-off sentiment shows in flows into Smart Beta ETFs, and in particular low volatility strategies. "We've seen record flows into risk-based products such as minimum variance ETFs since the start of the year," comments Samadder. "Approximately EUR2 billion of new money has flowed into low volatility ETFs listed in Europe since the start of the year."

At the beginning of the year, emerging market bonds were popular but have become increasingly less so as the year has advanced. "This reflects the sentiment," Samadder says. "Flows are muted now which has a lot to do with US monetary policy. If the US does raise rates it could negatively impact emerging market assets."

Tactical use of inverse ETFs, expressing a negative view on the market, has seen increased flows.

"They provide a daily inverse exposure to the index to reflect the opposite of the market move on the market on a daily basis," Samadder explains. "But over longer holding period, these products experience a negative volatility drag so it is important investors understand that they are designed to be used as short term, tactical trading tools and not buy and hold products."

The audience for these products tends to be smaller institutional and retail investors who trade daily, trying to leverage off the fact that markets are very volatile at the moment.

Another big theme in the market has been inflation protection. "The risk of inflation is to the upside; we have seen slightly better inflation data in the US and there has been a lot of flow going into inflation linked bonds and break even products," Samadder says.

Lyxor's Inflation Expectations ETF is designed to track pure inflation expectations. "In a normal inflation linked bond you are exposed to interest rates and inflation; this hedges out the interest rate component to give you very little exposure to interest rate moves," Samadder explains. It is achieved by the ETF going long a basket of inflation-linked bonds and short a bond of nominal bonds of the equivalent duration.

"It gives you protection against rising interest rates but you are getting exposure to inflation going up," he says. 

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