Investors in exchange-traded funds spent September acting like their family won’t stop asking when they’re getting married: a little defensive.

September was a muted month for ETFs, but some flows show investors beginning to move toward defensive positioning. Sector ETFs writ large saw $112 million exit in September, according to State Street’s September Flash Flows report. But a single subcategory, defensive sector funds, had net inflows, at $1.8 billion. Meanwhile, low-volatility funds also saw an uptick in flows, and bond ETFs took in a bigger share of flows than normal. Separately, these events would be one-offs, but together they paint a defensive picture, said Athanasios Psarofagis, an ETF analyst at Bloomberg intelligence.

“While it’s not overwhelmingly like people are freaking out and moving out of the market, there definitely was a little bit of a downshift,” Psarofagis said. “This looks like people were getting a little conservative in September.”

Something New? Or Something Borrowed?

For most of the year so far, investors have tried to catch tech’s upside, but September saw $3.4 billion go into funds with lower volatility, according to Bloomberg data. Meanwhile, bond ETFs captured 41% of flows, far above their long-term average of about 30%. The utilities sector brought in $1.5 billion, and real estate attracted $868 million, despite both sectors having negative returns of about 6% this month, according to State Street.

But flows into one fund hint at investors creating shares that borrowers may then short, said Matt Bartolini, State Street’s global head of research strategists:

• “While we still need more data to see where [State Street Utilities Select Sector SPDR ETF] XLU or even other utilities ETFs short interest is going … we did start to see an uptick,” Bartolini said.
• Something similar happened in 2020 with falling energy prices that attracted flows to the company’s Energy Select Sector SPDR ETF (XLE). “They actually turned out to be these long-to-lend trades where the shares were being created not because of a positive view, but for a negative view,” he said.

Cold Feet: Returns across sectors have diverged more recently, with some portions of the market driven more by (bad) economic headlines and some driven more by company fundamentals, Bartolini said. And during periods with fewer earnings reports and less company news, macro headlines tend to dominate market behavior. “Until the macro fragility solves itself a little bit and you start to have less fraught headlines on the macro front, you will continue to see this trade-on, trade-off of macro-on and macro-off during months in which there are lesser earnings reports versus greater,” he said.

Like Labubus and tinned fish, ETFs are very in style.

Launches are breaking records and issuers are increasingly introducing ETF versions of existing strategies: As of Oct. 8, there are 194 converted ETFs, 142 ETF clones and 50 exchange-traded funds as a share class on the market, according to data from Morningstar. With roughly 5,718 ETFs and 6,202 mutual funds currently, the number of ETFs is expected to overtake the number of mutual funds for the first time in February 2027, said Ben Johnson, head of client solutions at Morningstar. It’s just the latest evidence that mutual funds have become a legacy product, with investors putting $9.6 trillion to work in markets via ETFs over the past 25 years, during which time mutual funds saw $319 billion in outflows.

The preference for the ETF wrapper is clearest in the case of ETF clones, Johnson said. The Fidelity Total Bond Fund’s ETF clone saw $27.6 billion in net new flows over the five-year period ending Sept. 30, for example, while the mutual fund gathered $11.2 billion in net flows over that same span.

“As a very tax-focused practice, I’ve always used ETFs to avoid realizing capital gains on rebalancing,” said Robert Persichitte of Delagify Financial. “Now, with more choices in the ETF space, it feels like a no-brainer for me.”

Low-Cost, Tax Efficient and Here to Stay

Unlike the viral elf plush toys, ETFs don’t appear to be going anywhere:

• As advisors have moved toward index-based investing, ETFs have increasingly been used more than mutual funds. And advisors who found a need for alpha could still reduce client costs by using an actively managed ETF over a mutual fund, said Greg Welborn, principal at First Financial Consulting.
• Gregory Furer of Beratung Advisors said that his firm is rapidly adopting ETF versions of mutual funds in taxable accounts. “Moving to the ETF structure lets [clients] take more control over when they realize capital gains, which fits directly into the tax planning work we do,” he added.

Tax Troubles. But just because an advisor may prefer the ETF structure doesn’t necessarily mean it makes sense to liquidate mutual fund holdings, particularly when doing so could trigger a significant taxable event, said Brittany Christensen, senior vice president and head of business development at Tidal Financial Group. “We expect the transition to happen much more naturally through new allocations, portfolio rebalancing and tax-efficient opportunities to migrate existing assets.”