In market panic run on S&P 500, investors favor three stock and bond alternatives

  • Investors pulled close to $20 billion from flagship S&P 500 ETFs in March.
  • February and March recorded consecutive outflows, the first time that's happened since 2008.
  • But investors abandoning U.S. large-cap stocks aren't leaving the market.

If there's one piece of advice that investors should take to heart, it's that they are almost invariably not smart enough to time the market. Going to cash means not just avoiding the Dow's worst days but missing out on the days of the biggest gains — usually only a few a year — and being left with the difficult task of trying to figure out when to get back into stocks.

But one thing investors have been doing that does make sense is cutting exposure to the S&P 500 — in a big way.

Exchange-traded fund investors bailed on the S&P 500 in March to the tune of near-$20 billion in outflows from two flagship large-cap stock index ETFs, which led outflows among all ETFs.

A fighting bull goes around Estafeta corner on the sixth day of the San Fermin running-of-the-bulls on July 11, 2011 in Pamplona, Spain.
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The S&P 500 exodus in particular sends the message that large-cap stock leaders of this bull market are no longer a free lunch, and that makes sense — it's even a little late for those investors just getting the message about diversification and asset allocation. But a deeper dive into the ETF flows in March, and the ETF performance leaders this year, shows where investors who do believe in staying in the market are going rather than the S&P 500.

Here are the three ETFs that led inflows, according to FactSet, in a brutal month that ensured the February-March period combined would be the first time there have been consecutive monthly outflows from ETFs since 2008 — and three straightforward lessons they reveal about investing.

1. iShares Core MSCI EAFE ETF (IEFA): $5.2 billion
2. iShares Russell 2000 ETF (IWM): $2 billion
3. iShares Short Treasury Bond ETF (SHV): $1.8 billion

1. Stock diversification means not limited exposure to the U.S. market, no matter what Buffett and Bogle say.

2. If you insist on a U.S. stock-centric view of the world, at least accept that a trade war makes a good case for adding small-cap market exposure: It is a universe less exposed to overseas revenue.

3. No matter how many times the traders and talking heads say the bull market in bonds is over and it's time to sell bonds, investors will flock to bonds in periods of uncertainty, and there was every reason to expect that after nine years of gains, a correction was in the cards. Bonds still are not doing well, but investors who want to maintain exposure to bonds have been shortening up on bonds they are holding.

Year-to-date SHV is up, though not by much, and IEFA and IWM are both down, though by less than U.S. stock indexes. But the point is not to head to a hot bet, it's to have an investing plan that makes sense over the long term.

"Even long-term-focused investors are nervous now," said Neena Mishra, director of ETF Research at Zacks Investment Research. "Factors that drove fund flows are easy to understand— small-cap outperformance due to trade concerns, international diversification and shortening of duration of bond portfolios," she said.

The S&P 500 outflows were led by the SPDR S&P 500 (SPY), which bled more than $10 billion, but the SPDR family has never been the best read on the individual investor as its history has been more closely associated with institutions and traders who were early into ETFs. The iShares ETFs, though are tools used by advisors. Its S&P 500 ETF saw more than $9 billion in outflows in March. "The fact that iShares Core S&P had a big outflow, it looks to me that it's a reflection of advisor-led reallocating," said Mitch Goldberg, president of investment advisory firm ClientFirst Strategy.

A look at what is doing well this year from a performance standpoint indicates why going with what's hot is hard to justify. Here are the top 5 ETFs year-to-date in performance, based on data from XTF.com, and excluding leveraged ETFs and ETNs.

1. iShares Latin America 40 ETF (ILF): 10 percent
2. iShares North American Tech Software ETF: 9.8 percnet
3. Teucrium Agricultural Fund (TAGS): 9.7 percent
4. First Trust Dow Jones Internet Index (FDN): 9.7 percent
5. iShares MSCI Malaysia ETF (EWM): 9.6 percent

Also in the top 10 year-to-date: country funds for Vietnam, Nigeria and the United States Oil Fund (USO).

An investor can chase performance in emerging markets or make a commodities market bet, and that's fine for "play" money, but not core investing.

The First Trust Dow Jones Internet Index hasn't only been a big winner in terms of performance but in terms of flows as well, and remember that even as tech stocks get clobbered the tech sector within the S&P 500 isn't doing nearly as badly as most of S&P sectors this year. FDN and PowerShares Dynamic Software (PSJ) are both in the top 10 among ETFs this year. Long-term bets on tech do make sense. "It [FDN] was one of the best-performing ETFs of the nine-year bull-run and continued its outperformance in Q1 as well," Mishra said.

But it is also the most popular ETF with significant exposure to the FANG stocks — not a place for investors to find additional comfort right now.

"The fact that oil rose during the quarter doesn't make it surprising that USO was in the top ten. ... That certainly explains Nigeria being among the top ten as well," Goldberg said. "As far as the software focused ETFs, I would expect their rankings to be pretty precarious with the tech sector in general taking a tumble."

There's no solution for a selloff, but sense is a better response than panic, or rashly going to cash. For investors who never got the message about not being 100 percent U.S. stocks during the past decade of good fortune, now is as good a time as any to learn it.

More from ETF Spotlight:

Watch: ETFs with the biggest exposure to Amazon
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