Emerging market investors buy ETFs

The growing popularity of exchange traded funds (ETFs) has been particularly notable among private investors seeking exposure to emerging markets, according to Barclays Stockbrokers, the UK’s biggest sharedealing company.

The broker recently reported a 157 per cent year-on-year increase in total ETF trades among its investor base. FTSE 100 and corporate bond ETFs are the most traded of these index securities, but investment in emerging market ETFs has been catching up – thanks to volume increases of up to 1,100 per cent.

The iShares FTSE/Xinhua China 25, an ETF that tracks the largest Chinese companies listed in Hong Kong, was the fourth most popular ETF traded by Barclays’ clients in August, followed by the iShares MSCI Emerging Markets and iShares MSCI Brazil.

Des Byrne, Barclays Stockbrokers’ managing director, says: “Investors have increasingly turned to ETFs as they seek simplicity, transparency and economy. Emerging markets ETFs are proving more and more popular as they combine these features with trading flexibility and handle difficult stock selection in foreign markets automatically through index tracking.”

But in spite of the growing take-up, many advisers question whether ETFs – like other index-tracking funds – are the best way in to emerging markets.

Conventional wisdom suggests that low-cost tracker ETFs are a better choice than active funds in developed stock markets such as the US and UK, because developed markets are “efficient” – they are heavily researched and liquid, and higher-charging active fund managers struggle to provide an edge.

However, active managers should be better able to outperform in emerging markets, say advisers. These markets tend to be less well researched, so managers may have more chance of spotting undervalued opportunities.

“Active managers can really add value in emerging markets – they can be more selective,” says Adrian Lowcock, senior investment adviser at Bestinvest.

By contrast, ETFs – and other index-tracking funds – are effectively forced to have higher exposures to shares that have risen strongly or that are the biggest constituents of indices, even if these do not offer the best investment prospects.

Peter Lucas, investment strategist at RBC Wealth Management, says many indices “reflect yesterday’s success stories rather than tomorrow’s”, and the weightings in some ETFs may not appeal.

For example, the iShares MSCI Emerging Markets ETF contains bigger allocations to South Korea and Taiwan than to the less developed economies of Russia and India.

Similarly, about half the iShares FTSE/Xinhua China 25 is in the financial sector. iShares MSCI Brazil has nearly half its portfolio in just two companies – Petrobras and Vale, oil and iron ore producers, respectively. An actively-managed fund could reduce this concentration to limit risks.

Performance figures for global emerging market funds and ETFs suggest that active managers can outperform. In the past year, several active funds have offered returns in excess of 100 per cent – about 20 percentage points ahead of ETF performance, according to Morningstar. Even average active funds have broadly matched ETFs. However, over three years, the average fund has not kept up with the index – underlining the importance of fund selection.

Among active managers, Lowcock likes First State’s funds, particularly for Asia, because of their good longer-term performance and the company’s relative caution. However, the table shows that two of its global emerging market offerings have lagged the recent recovery. Mick Gilligan, head of research at Killik & Co, the advisers, currently favours Lazard Emerging Markets and Utilico Emerging Markets – a specialist infrastructure fund offering a good yield. Advisers also point out that while ETFs are certain to lose money when markets drop, an active fund may reduce this pain.

Nevertheless, emerging market ETFs can have attractions in some situations. Capturing the benefit of substantial short-term price rises in emerging markets can be easier through ETFs, says Gilligan. “There are certain types of market conditions – like this year – where ETFs do well,” he says. The ability to deal throughout the day at known prices is also an attraction over unit trusts – where investors can only buy or sell at one daily point and without knowing the price in advance.

Gilligan adds that for certain less-developed markets, such as Vietnam, an ETF can provide an index return through a “swap”, while active fund investors may be dependent on the less predictable performance of property and private equity holdings. This “outsourced replication” offers the prospect of perfect tracking (before fees), say supporters, but such ETFs also carry counterparty risk for investors – the danger that the swap guarantor might not pay the index returns.

Justin Modray of CandidMoney.com, the financial website, suggests that it could be worth combining ETFs and active funds. “Using ETFs as a partial hedge is no bad idea,” he says.

An ETF at should at least avoid the risk of a manager significantly underperforming. “What it comes down to is whether investors can find active managers who can add value consistently,” says Lucas of RBC.