The comeback of Cathie Wood's ARK Innovation fascinated investors in 2023. But it's only part of the year's story — and the details reveal where the best ETFs and S&P 500 are headed.
To be sure, Wood's ARK Innovation returned more than 72% in 2023 through Dec. 26, says Morningstar Direct. That makes the $9.5-billion-in-assets ETF the top-performing actively traded U.S. diversified ETF this year. It's winning by quite a bit — topping Fidelity Blue Chip Growth ETF's 58% return. And it easily tops the S&P 500's 26% return.
But if you look beyond just U.S. diversified ETFs, ARK Innovation's returns look less impressive. The fund's performance ranks it just 70th out of the entire universe of ETFs in Morningstar's database.
What's beating ARK?
Investors Go Beyond S&P 500 For Big Returns
The fact that ARK Innovation's returns pale amid the full ETF universe tells the true story of 2023. Risk is in. Even more speculative plays on cryptocurrency plus leveraged investments on AI leader Nvidia and cryptocurrency firm Coinbase are blasting past ARK. GraniteShares 1.5x Long COIN Daily ETF, which amps up returns on Coinbase, is up 634% this year.
In other words: Investors can't seem to take on enough risk going into 2024. Now that it's looking like the Federal Reserve will cut interest rates in 2024, investors think it's safe again to speculate. Think bitcoin.
"ETF performance in 2023 reflects a resurgence of interest in higher-risk, growth investments," said Roxanna Islam, head of sector and industry research at Vetta Fi. "Top-performing ETFs included blockchain and crypto equity ... which benefited from higher bitcoin prices from news of the pending spot bitcoin ETF launch."
Interestingly, though, most investors played it safe during much of 2023, said Matthew Bartolini, head of SPDR Americas Research, State Street Global Advisors. That's because the Fed chilled speculation for most of the year by raising interest rates.
ETFs tied to government bonds enjoyed strong flows of money all year, Bartolini pointed out. Investors also poured cash into U.S. large-cap stock funds. But caution went to the wind when investors sensed rate hikes were over.
These ETF flows "reflect investor behavior that was hesitant to express risk through 10 months of year, only to capitulate and go risk-on in November and December when it was clear rate cuts were on the horizon," Bartolini said.
Looking At Large-Cap Tech
Investors' whipsaw from playing it safe to speculating was nowhere more apparent than with the so-called Magnificent Seven. The seven largest tech-related S&P 500 stocks drove a bulk of the S&P 500's gains in 2023.
Investors paid up for these companies, many due to their exposure to AI. These big tech stocks are seen having such huge growth ahead of them, they were somewhat insulated from rate hikes. Tech dominated all the top sector funds in 2023. ARK Next Generation Internet ETF was No. 1 with its 100% return. It was closely followed by MicroSectors FANG+ ETN, with a 97% return. "It's Momentum Chasing 101," Bartolini said.
Islam, though, said S&P 500 tech stocks offered a safe haven.
"Large-cap technology stocks benefited from the AI boom despite higher interest rates and the possibility of recession," Islam said. "While large-cap tech has significant growth potential, there is also a sense of safety from high-profile stocks with large industry scale."
What Investors Are Avoiding
If speculation and tech were all the rage, what was out? Energy and caution.
The worst ETFs of the year included ProShares Ultra Bloomberg Natural Gas, which posted a whopping 92% total loss. But betting against tech stocks was also costly. The MicroSectors FANG+ 3X Inverse Leveraged ETN plunged more than 90%, too.
Dividend and utility stocks were poor performers, as well. Their yields looked less impressive when investors could score 4% or more by simply putting money in a savings account. The SPDR S&P Dividend ETF lagged with a 2023 return of just 2.5%. And the Utilities Select Sector SPDR ETF declined 7.7% on the year, even including dividends.
Investors simply found new ways to get income in 2023. "While dividend ETFs weren't that popular in ETFs, there was a rise in covered-call ETFs like JPMorgan Equity Premium Income and JPMorgan Nasdaq Equity Premium Income," Islam said. Both ETFs generate income by selling options on S&P 500 stocks they hold.
Utilities And ESG Are Out
"(Utilities') earnings growth and sentiment, as a result, was similarly left out of the 2023 S&P 500 rally. With broad growth challenged, areas that were weak were shunned," Bartolini said. "Utilities have historically performed well during recessionary periods, but no recession came in 2023; that further weakened the case for utilities."
Another area ETF investors shunned? Environmental, social and governance (ESG) funds, Islam said.
"The largest outflows were seen in iShares ESG Aware MSCI USA ETF — an ESG ETF. This year investors were focusing more on returns rather that qualitative factors that underlie ESG ETFs or certain thematic ETFs," she said.
What's Coming For ETFs In 2024?
There's one thing that never goes out of style with ETF investors: low fees. Active ETFs with stocks picked by top-performing investment managers — like Wood — are also popular. Both trends are expected to continue.
"Low-cost funds took in 57% of all flows, and active funds took in 25% of all flows," Bartolini said. "On average, low-cost funds take in nearly 60% each year, so I think you can pencil that in again next year."
Active ETFs "have increased their market share of flows every year for the past five," he said. "I'd expect that to continue."
Expect some unwinding of overdone trends too, Bartolini said. That includes the surge of cash into money markets.
"Nearly a trillion dollars went into money market mutual funds as rate hikes boosted yields to 15-year highs. With rate cuts, as many as three or four likely to occur in 2024, all of that money is facing reinvestment risk. As a result, I'd expect money market funds to face redemptions, and that money going mostly into ETFs," he said.
Meanwhile, Islam thinks crypto ETFs are only getting warmed up. "Crypto will likely continue to be a top story in the first half of 2024, and I expect flows into spot bitcoin ETFs to be more significant than the ether futures ETF launch in 2023," she said.
Return Of S&P 500 Sectors
Technology dominated so much all year, investors didn't bother with other sectors. Flows into sector ETFs were muted in 2023, Bartolini said. But it's an area likely to revive in 2024.
"Taking on active risk with sectors just wasn't rewarded (in 2023)," he said. "Given how it's more probable than not that market breadth won't be as concentrated in 2024, sector allocations are likely to rise alongside the increased return dispersion."
But one thing's for sure. ETFs continue to be one of investors' favorite ways to play just about all asset classes. "With that in mind, over $800 billion of ETF inflows in 2024 is within reason," Bartolini said.
2023's Top-Performing U.S. Diversified ETFs
| Name | Ticker | YTD return |
|---|---|---|
| ARK Innovation | 72.18% | |
| Fidelity Blue Chip Growth | 58.36 | |
| Invesco NASDAQ 100 | 55.46 | |
| Invesco QQQ Trust | 55.29 | |
| Renaissance IPO | 53.20 | |
| Harbor Long-Term Growers | 52.81 | |
| Vanguard Mega Cap Growth | 51.91 | |
| Schwab US Large-Cap Growth | 50.50 | |
| T. Rowe Price Blue Chip Growth | 50.05 | |
| Motley Fool 100 | 47.38 |
