Rising stars of the ETF emerging market world

As more investors flock to emerging markets ETFM asks industry experts to discuss prospects for the region and how ETFs can be a valuable investment tool to gain access

Why are the emerging markets an attractive investment option? Are there any countries or sectors that are performing particularly well at the moment?

Paolo Giulianini: Emerging Markets (EM) have performed extremely well in 2010. The gauge was up by 16.4%, as measured by the MSCI EM index, compared to the Developed Markets (DM) which rose only by 9.55%, according to the MSCI World index. This performance was spread evenly across regions: Emerging Asia 12%, Latin America 17%, Emerging Europe 15%. Only the Bric countries lagged behind at 7%, mainly because of tightening policies which impacted markets in Brazil, India and China.
EMs also showed a higher degree of resilience than DMs to the credit crisis triggered by the US housing bubble, as their economies were able to cope better with it than others. Today EM equities are, on average, 15% below the pre-crisis peak, compared to a 22% gap for DM equities. Some markets in Latin America (Chile, Colombia and Peru) and in Asia (Thailand, Indonesia and Malaysia) are already well above their pre-crisis levels.

Mark Rodino: Emerging market equities significantly outperformed developed markets in 2010, and we are seeing more and more investors increasing their allocation to emerging markets as a way to try to access outperformance. While Brazil, China and the rest of the Bric countries remain in focus clients are looking to add less developed economies in Emerging Asia, such as Vietnam and Indonesia, to their portfolios.

What issues do investors need to consider when investing in the emerging markets?

Paolo Giulianini: Typically, EMs have always been considered as an exotic addition to a well diversified portfolio. Obstacles to investing in EMs for medium-small investors, such as difficulty in trading the local currency or limitations in investing in stocks for foreign non qualified investors, have kept EMs away from the mainstream of capital investing.
Nevertheless, things are rapidly changing. EM Earnings are currently just 1.5% below the pre-crisis peak, versus 18% for DMs, and the expectations are for a further increase. Performance continues to be supported by earnings per share growth, which is expected to be 16% in 2011 compared with 32% in 2010, for EM countries overall.
Volatility – typically a sore point for EMs – has been rather low in 2010, with DMs becoming more volatile than EMs at the end of Q3 last year. In this sense, EMs could be a good investment opportunity also for the year to come and we do not see a risk of a bubble at this stage.

Mark Rodino: Currency risk is something that investors should consider. Most ETFs are not currency-hedged. As such, an investor buying an Emerging Market equity ETF is taking an active stance on the local currency in addition to the usual market risk. For example, assume an investor is holding the HSBC MSCI Brazil ETF and marking-to-market their position based on the NAV of the ETF calculated in US dollars. If the underlying Brazilian shares rally 10% in Brazilian real terms, while the Brazilian real simultaneously weakens 10% versus the US dollar, the investor will have made zero gains on their ETF position (in spite of the local equities’ 10% gain). Most investors in Emerging Markets are, in fact, actively seeking this currency exposure and anticipate that Emerging Market currencies will strengthen versus those of developed economies.

Could ETFs help fuel a bubble?

Paolo Giulianini: ETFs are a cheap but effective way for investors to enter into the EM world. During 2010, nearly half of the European equity ETF inflows (€9.1bn) were directed to EM ETFs. ETFs offer any kind of investor, from the small retail to the wealthy asset manager, the possibility to invest in countries and markets that otherwise would be precluded to them, either due to cost or legal issues.
ETFs have brought EMs closer to a multitude of investors and, as a consequence, have opened their door to an increased flow of capital. However, it would be incorrect to say that ETFs have created a bubble. ETFs are a vehicle that can be used to invest in EMs; as such, they are no worse than a direct investment in local shares or in futures or other derivatives on EM indices/stocks. It is not the instrument that creates the bubble, even though it could help in fuelling it. Investors should remember the golden rule and always compare earnings and check market fundamentals before investing.

Mark Rodino: Emerging markets have suffered speculative bubbles in previous decades and long before ETFs arrived on the scene. ETFs have effectively decreased the frictional costs of accessing emerging financial markets and in so doing have raised the efficiency of capital allocation to these countries. Traditional ETFs simply reflect the underlying indices and therefore do not per se help fuel speculative bubbles in these markets.
 
Are ETFs good vehicles for tapping the emerging markets? Do ETFs help overcome obstacles hindering direct investment?
 
Paolo Giulianini: ETFs are the perfect vehicle to gain access to EMs. ETFs can be traded for sizes as small as one unit, which corresponds to an investment of a few euros, to sizes accounting for tens of millions of euros.
The great advantage of using ETFs is that they are traded on exchange like a local stock and hence keep the cost associated to executing and settling the transaction to a minimum, giving investors the possibility to buy and sell ETFs through their broker or directly contacting the market makers.
Furthermore, ETFs are available for trading across nine exchanges in Europe and most of them are listed in different currencies giving investors a tailor-made investment opportunity. They can be continuously traded from 8:00 to 16:30 GMT during the normal exchange’s opening hours on business days, even though the underlying markets, such as India, China, Brazil, Korea, and Russia are shut because of a holiday or simply because they belong to a different time zone. Thus a European investor can easily buy and sell ETFs tracking Asian indices in the afternoon as much as he can trade ETFs tracking Latin America indices in the morning.

Mark Rodino: ETFs are a good vehicle for accessing emerging markets for the reasons previously stated, but do not by themselves create liquidity where is does not exist in the underlying market. Over time, as AUMs grow and trading increases, the ETF can ‘become’ the market with its own pool of liquidity, and we have seen this in some of the US ETFs already.
Operationally, it is far more convenient for European investors to buy foreign markets via ETFs trading on their local exchanges during their local market hours.
Some ETF providers, such as HSBC, can offer access to Emerging Markets that restrict foreign ownership; for instance, HSBC has access to ‘local’ shares in China.
 
Is the emerging market ETF offering set to grow, as investor demand to access the region increases? How can ETFs tracking this region evolve?

Paolo Giulianini: European-listed ETFs on EMs give investors the widest choice and investment opportunities. Nearly 600 ETFs on EMs are available to investors in Europe. This is set to grow as issuers bring new ETFs to allow investors the chance to invest in new countries or in indices that follow innovative strategies, such as optimized indices that use a fundamental approach to the country/stock weighting, or leveraged/inverse indices. No doubt that the European market will affirm itself as the most comprehensive venue for trading ETFs on EMs.

Mark Rodino: Emerging Market ETFs saw unprecedented growth in 2010, both in terms of assets under management (AUM) and the number of products available. HSBC has an exciting pipeline of Emerging Markets funds to satisfy investor demand.
Going forward, as AUM grow in Emerging Market ETFs, we will naturally see greater liquidity and greater availability of inventory for short-selling. The increased liquidity on the short side of ETFs will allow investors to use ETFs as their hedging tool of choice.


Biographies

Paolo is director and head of ETF Trading and Market Making at UniCredit. He runs a team based in London, Munich and Milan. Prior to joining UniCredit in 2007, Paolo was head of Delta one in Banca IMI for 14 years, where he started trading ETFs when launched in Europe.

Mark is head of ETF Sales for Europe, Middle East and Africa (EMEA). He joined HSBC in May 2010, and is helping the bank launch its suite of HSBC -branded ETFs and also build out a pure-play ETF trading platform. Prior to joining HSBC, Mark was head of ETF sales for Europe at Knight Capital.