Flight to emerging market ETFs

Investors are flocking to the emerging markets and many are using ETFs to provide access. Matthew Craig looks at why there is a high level of interest and the potential investment risks

For a large number of investors, the emerging markets are now an attractive investment destination and in many cases ETFs are being used to make this journey. Or as Towers Watson senior investment consultant Chris Sutton said: “There is a lot of interest in emerging markets and a lot of interest in ETFs at the moment. It is potentially a happy marriage.”

In fact, ETF investors are now putting more money into emerging market equities than developed market equities. According to BlackRock, net new assets for emerging market equities in the first 10 months of 2010 were $36.8bn compared to $35.3bn for developed market equities.

BlackRock’s ETF data also showed that emerging market equities are now responsible for 18.6% of global ETF assets at the end of October, making this the second largest category after North American equities. Deutsche Bank noted the popularity of emerging market equity ETFs in 2010, stating that European equity ETF investors put €5.4bn into emerging markets in the first three quarters of the year, with developed markets looking relatively unattractive in comparison.

There are several reasons for the popularity of emerging markets. One of the most obvious is performance; the emerging markets have outperformed developed markets by 178% over the ten years to 30 September 2010, based on cumulative price index returns in US dollars of the MSCI EM index and the MSCI World index.

More recently, emerging markets have recovered faster from the global financial crisis than developed markets, despite falling further initially. Emerging markets also offer diversification away from developed markets, which should help to reduce risk in portfolios.

Many investors are also realising that their allocations to emerging markets are lagging behind changes to the global economic order. According to Baring Asset Management, data from the Investment Management Association shows that less than 2% of UK retail portfolios are held in emerging markets despite the fact that these markets now represent 16% of global market capitalisation.

In the past, some investors have had their fingers burnt in certain emerging markets, but there is now a wide recognition that many of these countries have strong macro-economic fundamentals, as shown by low debt to GDP ratios and current account surpluses. Emerging market countries are becoming less reliant on demand from the developed world, as they now have a growing middle class population which is increasing domestic consumption, creating a virtuous cycle of trade between different emerging markets.

Route into emerging markets

For many, investing in ETFs that track indices providing broad exposure is the most common way to tap emerging markets. This approach has the advantage of giving exposure to a wide range of emerging markets through a single investment.
But single country emerging market ETFs are becoming more common and are gaining ground among investors. Lyxor ETFs head of product development Lionel Phillips-Franjou said there have been a lot of inflows into the individual BRIC countries – Brazil, Russia, India and China.

He added that Lyxor now has €1.5bn in its MSCI India ETF, experiencing 380% growth since the beginning of 2009. The issuer also has €1.1bn in an ETF tracking Chinese H-shares and over €700m each in ETFs investing in Brazil and Russia.

Phillips-Franjou said: “What’s very interesting is the arrival of new challengers that are slightly smaller countries with very interesting stories”. He added that, for example, ETFs tracking Malaysia and Turkey have seen very rapid growth, as have ETFs providing exposure to Poland and Africa.

As well as equities, emerging market debt is becoming more popular, particularly as it is increasingly denominated in local currencies, rather than US dollars. BNP Paribas Asset Management co-head of EasyETF and index development Danièle Tohmé-Adet said: “Investors can get more of a currency effect through emerging market bonds and that can help maximise performance.”

Ashmore Investment Management head of research Jerome Booth said that emerging market debt as an asset class included sovereign dollar-denominated debt, but also corporate bonds and sovereign debt denominated in local currencies. On the latter, he said: “It is seen as a safe haven in currency terms and a refuge from the tensions and the weaknesses in the dollar and the euro.”

Sutton at Towers Watson said one of the big attractions of emerging market ETFs is their operational efficiency. “Emerging markets still come with a lot of hassle for investors and no small amount of risk in terms of custody settlement, FX transactions and the market rules are different everywhere. One of the beauties of ETFs for investors in the US or UK is that emerging market ETFs are listed on the London or New York stock exchanges, so they can sub-contract all that hassle to their ETF managers.”

In the same vein, Signia Wealth CIO and head of investments Gautam Batra said he invests directly where possible, but uses ETFs for emerging markets because they are an efficient way of gaining diversified exposure with what may be relatively small amounts of capital. However, Batra added it was not always possible to find the right emerging market exposure. “There is a risk of buying mediocrity with any very broad-based ETF strategy, as it is not targeting the securities we think are undervalued,” he said.

Index weighting

As they are normally market cap weighted, ETFs tend to hold the largest stocks in an index, which may be a disadvantage if small and mid cap stocks are outperforming. ETFs also depend on the liquidity of the underlying market to an extent, and this can be a problem in some smaller emerging markets.

Indeed certain markets are harder than others to access. Batra said: “For example, we haven’t been able to get the exposure to Chinese local markets. Chinese A-share ETFs don’t have reporting status and they are trading at a premium. There is clear room for development in ETFs to get targeted emerging market exposure”.

One way to invest in China via ETFs is through stocks listed in Hong Kong, but ETF providers are seeking more exposure to companies listed in mainland China with prices in the Chinese renminbi. Head of db-x trackers UK Manooj Mistry said: “Early this year we launched a range of China A-shares ETFs linked to companies on the Shanghai and Shenzhen stock exchanges and we have seen inflows of around $550m into them.”

Russia is another market where it can be hard for investors to get direct access to stocks. iShares sales strategist Sofia Antropova said: “There is not a defined settlement system and no central counterparty which brings more risk. To overcome this we launched a Russian fund in September this year and there has been a lot of demand from clients”.

Investing in emerging markets through ETFs brings up the issue of whether passively managed funds make more sense than using an active manager. In theory, an active manager should be able to add value in what are arguably less efficient markets, yet a single asset manager cannot necessarily be an expert on a wide range of emerging markets. “An active manager good at selecting Indian stocks might not be as good at selecting Russian stocks,” Antropova said.

Conversely, active managers claim they can reduce risk compared to broad-based emerging market ETFs by simply avoiding problematic areas which market cap weighted funds are tied to. Ashmore’s Booth said: “Only passive investors would have invested 25% in Argentina’s debt before it defaulted because it was 25% of the index at that time. For an active manager, it was the easiest call in history to avoid it.”

Tax implications

Investors also need to consider tax issues and the risks involved in ETF structures. When undertaking their due diligence, investors should look at an ETF’s structure as well as its tax status.

For emerging markets, many ETFs use swaps to obtain the market return rather than investing in a basket of underlying stocks from emerging markets, as these may be hard to obtain and will incur transaction costs. In theory, swaps should fully replicate the index return, but it can be argued that they bring in an element of risk. Sutton said:  “We continue to have a little bit of concern around swap-based ETFs.” He added: “By buying them investors are taking on counterparty risk. Are ETF investors adequately compensated for that risk?”

However, Tohmé-Adet said swaps helped ETFs reduce tracking error and costs. The fact they are packaged under Ucits III regulations and in a Mifid-compliant environment in many firms should also reassure investors. She added that ETFs had the advantage of intra-day trading compared to mutual funds, which are priced once a day. She said: “With mutual funds, you know your subscription will be booked at NAV of a day, a level not unveiled before the next day and that might not be suitable if you are expecting something to shock the market on that day.”

Finally, investors should remember that emerging markets, while reaching a new era of maturity, will continue to carry investment risk. Phillips-Franjou said: “Emerging markets are potentially high reward but investors should keep in mind that, as for any other investment, there are risks attached that investors should be comfortable taking”.

In this sense, ETFs should be seen as tools that are greatly increasing the ease of investing in a wide range of the world’s most dynamic economies.