This is part of a series on the global rise of exchange traded funds
The week after Donald Trump was elected US president, emerging market equities had their steepest sell-off since the financial crisis.
Shares in the developing world tumbled amid fears for the future of global trade. Within five days, the main index for emerging market stocks — the MSCI EM — had sunk 6.7 per cent. And exchange traded funds were one easy way investors used to express their newfound aversion to the sector.
Providing money managers and retail investors with a low cost to buy and sell assets, the rise of ETFs has in many ways been a boon for playing emerging markets. ETFs are popular in the developed world, but in emerging markets they are outrunning the competition. Of the $47bn that poured into EMt funds during 2016, three-quarters has been allocated to ETFs, according to data from EPFR.
However, their popularity is a double-edge sword for a sector that has historically been prone to abrupt changes in investor sentiment. When the temperature starts rising in the EM universe, ETFs increase the volume of investors who can move their money out quickly, says David Hauner, head of emerging markets at BofA Merrill Lynch.
“You can see that by the fact that even countries less vulnerable to higher US rates were selling off,” he says of the recent nervousness.
The lure of ETFs for EMs is understandable. In a sector where many investors want exposure without necessarily knowing a lot about the countries first hand, the chance to take a passive, benchmark-tracking position seems preferable to paying higher fees for active management.
“ETFs offer access to underlying asset classes typically harder to invest in — at a lower expense ratio and with diversification,” says Tom Bartolacci, head of ETF capital markets for Vanguard Europe. “So far equity has been bigger than fixed income in EMs but that is changing as the whole market grows.”
The International Monetary Fund says that while part of the increase of money flowing into EMs in recent years is down to improving economic fundamentals, the fact that even countries with deteriorating credit ratings have enjoyed rising inflows suggests something else is going on.
In a report published in December it ascribed emerging market capital flows to the rising popularity of index funds and benchmarks that facilitate capital allocation “independently of the respective country fundamentals”.
“There has been an extraordinary move into emerging market ETFs and that has put active managers under pressure,” says Geoff Dennis, head of emerging markets equity strategy at UBS.
Across the market, one of the best performers is the PowerShares FTSE RAFI emerging markets portfolio, which is up 35 per cent so far this year, according to Morningstar data. The PowerShares fund follows an index that bases weightings on book value, cash flow, sales and dividends rather than market capitalisation. Its structure answers one of the criticisms of EM ETFs — namely that the way the indices they track are calculated means they are dominated by certain countries and a few large, often state-owned companies, so fail to provide the sort of diversification investors expect from emerging markets.
In the main MSCI EM index, for example, China accounts for 27.5 per cent; Mexico is just 3.5 per cent and Poland a mere 1.1 per cent. One quarter of companies are state-owned enterprises, largely energy, telecoms and financials, which on average have underperformed non-state-owned companies since 2010.
But just as money can flow seamlessly into EM via passive baskets such as ETFs, investors have been quick to pull the trigger to liquidate at the first sign of stress.
Within a few weeks in November, billions of dollars were withdrawn. “It was dramatic,” says Mr Dennis of UBS. “Money was flowing out of emerging markets and into the US.”
Last month, the iShares MSCI Emerging Markets ETF (EEM) topped the list of ETF redemptions, with $3.5bn in outflows. Joining it in the top ten was the iShares JPMorgan USD Emerging Markets Bond ETF, with outflows of $900m.
Yet in spite of the concerns, and the sell-off following Mr Trump’s triumph, both Vanguard’s FTSE Emerging Markets ETF and iShares Core MSCI Emerging Markets ETF remain in the top ten for ETF inflows this year.
This partly reflects the fact that current account deficits in emerging markets are lower than they were three years ago during the “taper tantrum” — that hit the sector hard — rendering them less susceptible to external shocks. Major banks and investors including UBS, JPMorgan, Schroder Investment Management and Credit Suisse insist the case for EM remains compelling.
“The music’s still playing,” says Mr Lake at PowerShares. “But as the saying goes, you may want to dance closer to the door.” Others are less convinced, pointing out that one of the other problems is that longer term, EM returns have not been inspiring.
Take the Vanguard FTSE emerging markets ETF and iShares MSCI emerging markets ETF — the largest EM tracking ETFs. Morningstar data show that over three years, returns have been -1.2 per cent and -2.9 per cent respectively.
The upside, say ETF advocates, is that at least investors can cut their losses easily.
Age of the ETF stories
Exchange traded funds: taking over the markets
ETFs: everywhere but not yet a systemic risk
Jack Bogle: the lessons we must take from ETFs
Bank of Japan’s controversial masterclass in ETF investing
The differences between US and European ETF markets
Active managers still hanging on to ETF coat-tails in Trump world
Can the passive tailwind keep blowing for ETFs?
Rapid rise of the ETFs sparks growing pains