EMs are paying the price of ETF liquidity; Volatility inflamed by ability of exchange traded funds to exit quickly; Chances are high of mass exodus from EM; No framework for co-ordinating an orderly reversal of flows

February 12, 2014 10:05 am

EMs are paying the price of ETF liquidity

By John Authers

Volatility inflamed by ability of exchange traded funds to exit quickly

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.

Cost matters

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 inshare 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.

Liquid stocks more volatile

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.


February 12, 2014 7:15 am

Chances are high of mass exodus from EM

By Gene Frieda

No framework for co-ordinating an orderly reversal of flows

The risks posed by emerging markets relate less to their own vulnerabilities than to deficiencies in the global financial architecture. Financial intermediation mismatches, volatility mispricing and co-ordination failure threaten a train wreck in emerging markets and an atypical spillover to the weakest developed economies.

Thus far, the most extreme asset market weakness has been concentrated in a few countries. Public debt levels generally remain low, as does external indebtedness. Flexible exchange rates and large foreign reserve cushions are serving their traditional buffering role, thereby limiting the more egregious effects of capital flow reversals. And gross domestic product growth, while weaker than in the immediate post-crisis years, is hardly disastrous.

Then why are the emerging markets suddenly under pressure, with interest rates rising sharply, and why have developed country asset markets started to express concern?

Driven down to unprecedented levels during the past five years, real interest rates need to rise substantially across the emerging markets.

During the period preceding the 2008 global financial crisis, foreign capital inflows reached 15 per cent of GDP for the median emerging market country, and remained sizeable after the launch of the US Federal Reserve’s quantitative easing programme. Real interest rates in many emerging markets fell sharply, often to negative levels. In response, private credit growth boomed, following the same pattern as the eurozone periphery and central/eastern Europe a few years earlier. Only after real interest rates normalise will it be clear how much boom-time credit turns into bad debt.

On its own, the above story points to an overdue adjustment rather than a crisis. Instead, the global risks relate to two systemic policy challenges posed by the reversal in capital flows to emerging markets.

First, current low levels of volatility mask the degree of potential “risk”. As exchange and interest rate volatility fell during the 2000s, capital flows well exceeded emerging market GDP growth. Financing constraints eased, and whereas previously a 3 per cent of GDP current account deficit was considered the upper limit of “safe”, a number of countries could now run 5-10 per cent of GDP current account deficits with relative ease.

Volatility should rise, and potentially overshoot, as the US exits its unconventional monetary policies. Rising volatility across global markets forces a reduction in emerging market asset holdings for a given value-at-risk constraint, and this is exacerbated as diversification benefits across countries disappear. This toxic cocktail of rising volatility and a reversal of correlations undermined portfolio insurance strategies in 1987 and led to the failure of Long Term Capital Management in 1998.

In current circumstances, such a trigger could reveal a second problem: a systemic liquidity mismatch. Market prices could plummet and interest rates rise as investors flee emerging markets without the traditional buffering role played by bank dealers, whose market-making capacity has been hollowed out.

While the regulatory response to the 2008 financial crisis sought to reduce systemic banking risks, changes to financial regulation have further reduced the intermediation capacity of the developed countries’ banks, and indeed of their subsidiaries within the emerging markets.

Relative to past cycles, capital flows over the past decade were larger and concentrated in local currency debt. Non-resident holdings of local currency emerging market debt surpassed $2.5tn in 2013, up from $637bn in 2008. While emerging market governments benefit from borrowing in local currency, foreigners now carry unprecedented risk exposure. In past emerging market crises they bore only the credit risk on foreign currency denominated debt. Now they bear currency and convertibility risk, together with a large degree of interest rate duration risk.

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The disparity between the mountain of assets invested in less liquid emerging markets and risk-averse financial intermediaries will lead to periods of illiquidity, where investors encounter difficulties in liquidating positions, and contagion, where they are forced to sell more liquid assets in unrelated markets.

Taken together, one can spot elements of the 1987 Wall Street crash, the 1998 Asian-Russian crisis and the 2008 financial crisis in today’s financial market landscape. Concentrated common lenders, together with mispriced volatility, correlation and liquidity risk create contagion risk within and beyond the emerging markets. They influence the extent to which real interest rates will need to adjust, the potential credit losses associated with the rate adjustment and the distribution of losses.

It is in no one’s interest that creditors beat a hasty retreat or that debtors (or indeed asset managers) impose controls to prevent that retreat. Because the potential fallout is more of a market risk than a fundamental macro risk for developed economies, the odds of pre-emptive co-ordination by major central banks or the IMF are reduced.

Emerging market countries and investors alike face a potential prisoner’s dilemma: co-operation is optimal, but with no framework for co-ordinating an orderly reversal of capital flows, the chances of a mass exodus are high.


About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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