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Are exchange traded funds the best way to invest in emerging market equities?
Last week, I wrote a column arguing that the structure of ETFs, which allows trading through the day, had contributed significantly to the scale of the recent sell-off in emerging markets, and was helping to make the sector more volatile.
This prompted some scathing responses. The two main counter-arguments were that other macro factors were more important to the sell-off, which is true – but still avoids the issue of whether ETFs have accelerated volatility. The second complaint is that ETFs are far cheaper in terms of the fees they charge than alternative open-ended or closed-end funds. This is also undeniably true.
So let me address both issues. First, ETFs now dominate flows in and out of emerging markets, and the money held in them is plainly flightier than money held in other instruments. According to Strategic Insight Simfund, since the beginning of 2009 there have been six separate quarters in which emerging market ETFs have suffered net outflows. There have been no such quarters for actively managed funds in the sector, while the far smaller flows into open-ended funds have also been steady.
While it is true that ETF investors are responding to macroeconomic and corporate fundamental factors when they make buying and selling decisions, the money they hold is plainly impatient. This is not surprising, as a key advantage of ETFs is that they are liquid – hold assets in an ETF and you know that you can sell quickly. At the margin, this money helps to accelerate boom-and-bust cycles in emerging asset markets – and this in itself may not help their plans to grow.
For investors, though, the issue of fees should be critical. Arguably, the case for index investing rests on low fees. After all, future performance is unknown, but fees can be guaranteed to eat into return. All other things equal, therefore, investors should opt for the lower-cost vehicle.
Many argue that the case for index investing comes from the efficient markets hypothesis (EMH), which holds in its strongest form that as all information is already incorporated in share prices, it will be difficult or impossible to beat the market. But Jack Bogle, the founder of Vanguard and generally regarded as the godfather of index investing, suggests that the case rests on the CMH, or Cost Matters Hypothesis.
Normally, he is unquestionably right about this. But if a market is inefficient, it is easier to outperform an index, even after fees. And that is happening to ETFs in emerging markets. Compared with the developed world, they find it far harder to match their benchmark indices, while active funds find it far easier to beat them.
The iShares ETF that tracks the MSCI emerging markets index has underperformed its benchmark by 12.3 percentage points over the last decade, meaning an annual return of 8.73 per cent, against 9.31 per cent for the index – 58 basis points per year. For the main ETF tracking the S&P 500 the tracking error has been 7 bps; for the Russell 2000 index of smaller companies, 2 bps; and for the S&P 350 index it has been negligible.
There are reasons for this, as explained by Stephen Cohen, who manages the iShares EM ETF. It is often difficult to access markets; markets are open at different times, and the range of different countries means that using futures to help replicate the index is not practical.
He points out that tracking errors are reducing over time, as access to markets such as Chile and Colombia, or even Russia, grows easier. But they weaken the case for passive investing in emerging markets.
Why do active managers fare so well? Their fees should be an insuperable disadvantage as ETFs are virtually costless for those who already have a brokerage account. Active managers need to cover the considerable cost of attempting to pick stocks in far-flung corners of the world.
And yet in emerging markets, even after fees, active funds tend to be better. According to Morningstar, while the iShares EM ETF has dropped 10.88 per cent over the past year, the average active diversified EM fund shed only 7.5 per cent. Over five years, active mutual funds beat the ETF by 13.21 to 11.32 per cent. It appears there really are bargains to be found in EM, and that active investors find them.
What is going on? One argument is that the two percentage points of underperformance with ETFs represent the premium for their liquidity. You can always get out in a hurry, which is not true of a direct investment in shares in some emerging stock exchanges.
As further evidence, note that hedge funds – which force investors to tie up their money for long periods – perform well in emerging markets. According to EurekaHedge, Latin America specialist hedge funds gained 1.83 per cent last year, while the MSCI Latin America index fell 15.59 per cent. In the first month of this year they dropped 1.95 per cent, against an 11.88 per cent fall in the index.
Another perverse effect of ETFs’ search for liquidity is that in emerging markets, it is the most liquid stocks that tend to be the most volatile. Robert Holderith, founder of Emerging Global Advisors in New York, points out that Brazil, Russia, India and China are four of the five most volatile markets in the EM universe. A “Beyond Brics” index that excludes them (along with South Korea and Taiwan) has a standard deviation of 14.7 percentage points, compared to 19.3 percentage points for the main MSCI EM index. Indices of domestic consumer stocks, also relatively illiquid and under-represented in the indices, also show lower volatility.
Why could this be? It may well be because ETFs congregate in the large stocks that are the most liquid, and move in and out frequently; less liquid stocks are traded less regularly in consequence, and hence give investors a less bumpy ride.
Many of these problems can be addressed without jettisoning the ETF structure altogether. ETFs aimed at specific sectors or following particular styles or strategies – far less common than in developed markets – would help address the problem, and are beginning to take off. As emerging markets grow more efficient, some of these issues will fade, and ETFs’ cost advantages will grow stronger.
For now it appears that both investors and, arguably, the emerging markets themselves are paying a price for ETFs’ liquidity.
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