February 2, 2014 2:44 pm
Emerging markets are badly served by ETFs
Investment vehicles have helped to create another boom and bust cycle
Money is flowing out of the emerging markets. A debate is raging over whether this is the fault of the US Federal Reserve, which has effectively encouraged investors to bring their money back home.
That debate is right and proper. But the fund management industry must face a debate of its own. Just why has the money funding companies and governments in the emerging markets proved so fickle? Even given decisions by the Fed, how can sentiment towards such a large swath of the world turn so rapidly?
We must question how the developed world finances the developing world. And so exchange traded funds should come under question for the first time.
The raw facts are that a remarkable amount of money has been pulled out of EM with indecent haste; and that this was the first emerging market sell-off to be conducted mostly through ETFs. They now account for about $300bn of the $1.3tn in emerging market equities, according to Morgan Stanley – and yet the iShares ETF tracking the MSCI EM index, the biggest in the sector, launched only in 2003.
The streak of outflows now stands at 14 weeks, the longest such streak since 2002 – although Geoff Dennis of UBS points out that 2001, the year of the Argentine devaluation, saw a streak almost twice as long. Flows can stay negative for a while.
According to TrimTabs, emerging market ETFs suffered redemptions of $4.4bn (4.8 per cent of their assets) last week. Over the past three months, they have shed 15.8 per cent of their assets.
There has been no particular economic trigger in the EM universe. Ugly political eruptions have come in countries already perceived to carry a high political risk, like Argentina, Ukraine, or Turkey.
So why such a swift flight of capital? A sharp turn in western investors’ sentiment need not have such an effect, as emerging markets investing should be about patience. They are volatile. It could take time for their value to shine through.
Closed-end funds, with no need to buy or sell shares in response to swings in sentiment among their investors, should be the ideal vehicle. Saker Nusseibeh, chief executive of Hermes Investment Managers in the UK, points out that the Foreign & Colonial Investment Trust was investing in Brazil, Russia, India and China in the 1880s – without the aid of acronyms, and with no need to sell if investors sold their shares in the fund.
Closed-end funds have disadvantages. But what can possibly have changed about EM assets so that it now makes sense to hold them in vehicles designed to be readily entered and exited by the minute throughout the trading day?
Index methodology itself has a problem. Weighting by capitalisation means money goes to the biggest firms – often formerly nationalised utilities, resources groups and oligopolists – and not smaller companies. Debt indices send capital to countries with the most debt. While more specialist sectoral ETFs are common for the US, EM remains dominated by big indices. And EM ETFs tend to lag their target indices far more than ETFs in developed markets.
Can these problems be fixed by internal tinkering? Last week saw the launch of the S&P Emerging Markets Domestic Demand index, focusing on companies that serve the growing middle-class. It will doubtless soon be the basis for an ETF.
So ETFs can indeed be improved. Do away with the notion that “emerging markets” is one coherent asset class, and a gimmicky fixation with acronyms, and it will help. Ditch bond indices that send the most money to the most indebted nations, and stock indices that send capital to oligopolists and the concept will improve.
But the notion of trading in complicated, heterogeneous and often illiquid markets using ETFs has had its day.
They have misallocated capital, and helped to create yet another boom and bust cycle for the emerging world when many countries had fixed deep-seated institutional problems.
There are better ways to invest in emerging markets than through ETFs.
That debate is right and proper. But the fund management industry must face a debate of its own. Just why has the money funding companies and governments in the emerging markets proved so fickle? Even given decisions by the Fed, how can sentiment towards such a large swath of the world turn so rapidly?
We must question how the developed world finances the developing world. And so exchange traded funds should come under question for the first time.
The raw facts are that a remarkable amount of money has been pulled out of EM with indecent haste; and that this was the first emerging market sell-off to be conducted mostly through ETFs. They now account for about $300bn of the $1.3tn in emerging market equities, according to Morgan Stanley – and yet the iShares ETF tracking the MSCI EM index, the biggest in the sector, launched only in 2003.
The total pulled out exceeded the sums that exited during the 2008 crisis, even before emergency rate rises in Turkey, India and South Africa.
According to TrimTabs, emerging market ETFs suffered redemptions of $4.4bn (4.8 per cent of their assets) last week. Over the past three months, they have shed 15.8 per cent of their assets.
There has been no particular economic trigger in the EM universe. Ugly political eruptions have come in countries already perceived to carry a high political risk, like Argentina, Ukraine, or Turkey.
So why such a swift flight of capital? A sharp turn in western investors’ sentiment need not have such an effect, as emerging markets investing should be about patience. They are volatile. It could take time for their value to shine through.
Closed-end funds, with no need to buy or sell shares in response to swings in sentiment among their investors, should be the ideal vehicle. Saker Nusseibeh, chief executive of Hermes Investment Managers in the UK, points out that the Foreign & Colonial Investment Trust was investing in Brazil, Russia, India and China in the 1880s – without the aid of acronyms, and with no need to sell if investors sold their shares in the fund.
Closed-end funds have disadvantages. But what can possibly have changed about EM assets so that it now makes sense to hold them in vehicles designed to be readily entered and exited by the minute throughout the trading day?
Beyond the basic structure of ETFs, there are flaws in the way they track indices and in the way emerging markets investments are marketed by Wall Street and the City. This starts with the absurd attachment to acronyms, which dates back to Goldman Sachs’ success in marketing funds tied to the Brics – Brazil, Russia, India and China. This led to a gush of funds into those countries, and has been followed by a series of increasingly contrived acronyms, including CIVETs, BIITS and MINTs. This is not a sensible way to allocate capital.
Can these problems be fixed by internal tinkering? Last week saw the launch of the S&P Emerging Markets Domestic Demand index, focusing on companies that serve the growing middle-class. It will doubtless soon be the basis for an ETF.
Emerging Global Advisors in New York offer specialist ETFs covering the “Beyond Brics” nations – excluding the Brics, Korea and Taiwan – and focusing on EM demand. Less mature countries and sectors are less correlated to the developed world and less volatile.
But the notion of trading in complicated, heterogeneous and often illiquid markets using ETFs has had its day.
They have misallocated capital, and helped to create yet another boom and bust cycle for the emerging world when many countries had fixed deep-seated institutional problems.
There are better ways to invest in emerging markets than through ETFs.
Copyright The Financial Times Limited 2014.
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