Emerging markets slowdown hurts passive funds

Fund managers prove unwilling to close lossmaking exchange traded funds
Downing tools: a fall in the price of oil and indications of a slowdown in China have dented investor confidence in the outlook for emerging economies © Kim Kyung-Hoon/Reuters

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No one likes the feeling of giving up and asset managers are no exception. Each year the industry launches hundreds of funds, but only a fraction of the unsuccessful ones are closed.

One of the most telling examples of the industry’s unwillingness to turn its back on poorly performing funds comes from one part of the rapidly expanding exchange traded fund industry: emerging market ETFs.

ETFs, which give investors cheap exposure to an ever-increasing range of countries, sectors and securities by tracking an index, have arguably become the most successful innovation of the asset management industry over the past decade. These passively managed funds attracted net inflows of $372bn in 2015, a 10 per cent increase on the previous year, bringing total industry assets to $2.99tn, according to ETFGI, the research firm.

But emerging market-focused products have been a persistent weak spot within the story of huge ETF asset growth.

Emerging market equity ETFs experienced the highest net redemptions of any ETF sector in 2015. A total of $16.9bn was taken out of emerging market equity ETFs compared with $83.1bn of inflows to European equity ETFs and $57.8bn of inflows to global equity ETFs, ETFGI figures show.

The high rate of redemptions followed $1.2bn of withdrawals from emerging market equity ETFs in 2014, which was once again the sector worst afflicted.

Passive managers of ETFs and other index-linked products face the same challenges as active fund managers. The prospect of further interest rate rises in the US, a fall in the price of oil and a slowdown in China have dented investor confidence in the outlook for emerging markets.

Emerging market volatility has been particularly painful for several ETF providers, which have seen some of their products dwindle to tiny levels of assets under management.

Although these emerging market ETFs are now so small they are running at a loss for parent companies, the providers are unwilling to give up on the funds altogether.

ETF Securities, the European asset manager, for example, has seen the assets of its China A-share ETF, which provides direct exposure to China’s stock market, shrink from $30m at the start of 2015 to $16m.

James Butterfill, head of research and investment strategy at ETF Securities, says the China fund needs at least $35m of assets to break even.

Mr Butterfill says: “At the moment [the China ETF] is costing us — it’s expensive. We launched [the ETF] at an unfortunate time for China. But we don’t have any intention to shut it down. As a firm we have a $50m cash-pile and it would take a long time for us to eat into that.”

WisdomTree, the US fund house, has also seen its emerging market equity income ETF shrink to $20m over the past year, while the assets of its emerging market small-cap equity income ETF have fallen to $10m. Both products managed $30m at their peak, says Hector McNeil, co-chief executive of WisdomTree Europe.

He says: “We are quite happy to carry those funds below a certain level [of assets] while we feel there will be softness in those markets. Most people will keep emerging market products going, even though the assets might be [falling]. “We all believe the emerging market space will recover. Investor allocations have dropped a lot in emerging markets, but they haven’t gone away totally. I think there is still a bit of pain to be had, but there will be a point where people think emerging market equities look cheap.”

Source, one of Europe’s largest ETF providers, similarly suffered a steep decline in the assets of its China ETF over the past 12 months, from a peak of $590m at the start of 2015 to $12m today.

The assets of its main emerging market ETF have fallen from $350m to $133m over the same time period.

Chris Mellor, director for equities product management at Source, says: “There are still China ETFs out there and we anticipate to continue to have a China ETF . . . We have no plans to close our fund — that would be very premature. I just don’t see China disappearing from the investor radar.”

Paul Jackson, head of multi-asset research at Source, adds: “Emerging markets is always a topic of conversation given the low valuations and high yields available and how much currencies have suffered — investors are wondering if there isn’t some value there now.”

Such reluctance to abandon unprofitable products is not unusual. Just 270 ETFs were closed in the 11 months to the end of November 2015, compared with 822 launches. Of the funds that closed, only 11 were emerging market focused, according to figures from Morningstar, the data provider.

BlackRock, the world’s largest asset manager, is one of the few investment companies to have shut down emerging market ETFs last year, accounting for five of the 11 closures. The ETFs it shut down in August of last year had between $2m and $20m of assets.

BlackRock also encountered the highest outflows from any emerging market ETF last year, after investors pulled $5.9bn from its MSCI Emerging Market ETF, which now oversees $21bn of assets.

Ursula Marchioni, head of the investment strategy Emea at iShares, BlackRock’s ETF arm, is cautious about an imminent recovery in emerging markets but hints at potential improvements.

“Signs that we are reaching the bottom would include a turnround in emerging market growth rates, as well as a potentially more dovish Fed. It is difficult to call the bottom but investors could take tentative steps into specific markets that are better positioned,” she says.

Letter in response to this report:

Exchange traded fund providers should be treated fairly / From Bruno Poulin and Antoine, Moreau

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