ETFs and emerging markets

Emerging markets and exchange traded funds (ETFs) have one thing in common: both are destined to hold increasing importance for investors for many years to come. Emerging markets offer some of the strongest long-term return prospects as they take their place in the global economy of the 21st century. The BRIC countries are widely predicted to become some of the biggest economies, yet there are many other nations set for growth too, in Asia, Latin America, Eastern Europe and the Middle East.

The growing importance of ETFs stems from the fact that they offer investors one of the most efficient, cost-effective and convenient ways to access returns both from emerging markets and an increasingly wide range of other investment opportunities around the world.

So just what are ETFs? ETFs track indexes but, unlike “tracker” mutual funds, they are also shares that can be bought and sold on the stock market in the same way as any other shares. They provide access to a whole market through the purchase of just one share. Investors can purchase shares through existing stockbrokers.
There has been an exponential growth in the number of ETFs offered to investors in recent years. At first, ETFs gave investors access to mainstream indexes (the first mainstream ETF was launched in 1993 and tracked the S&P 500), but increasingly they are giving access to much more exotic markets and sectors in ever more innovative ways. Given the rapid development and popularity of emerging markets, it is hardly surprising that ETFs are being launched to cover these markets, too. ETFs offer investors many advantages in accessing emerging markets.

The first big advantage of ETFs is that they are a convenient and cost-efficient alternative to purchasing all of the underlying securities of a particular index. Structured as a single security, traded on an exchange just like a stock, ETFs empower investors to access entire indexes in one go. Clearly, investors may wish to go for stockpicking funds, but this can be a risky approach, as you might fail to pick the right fund manager. Much of the interest shown in ETFs has come from the realisation that the vast majority of returns in any given investment portfolio result from long-term asset allocation decisions rather than short-term market timing expertise. In fact, academic evidence indicates that the majority of fund managers underperform their benchmark indexes. This is especially true during periods of high market volatility, for which emerging markets are noted. ETFs simplify the asset allocation process by giving low-cost access to particular indexes. This makes them the perfect ‘beta’ investment for investors who implement a ‘core-satellite’ investment approach. ETFs can also be used to give effective exposure to particular emerging market countries or regions, with the ability to rotate this exposure as and when required.

At present, there is a big question mark over whether in the next few years it would be a good move to take a stockpicker approach to emerging markets. At a roundtable discussion held by Lyxor ETFs on emerging markets, Robin Griffiths, a fund manager at Cazenove Capital Management and a noted technical analyst, pointed out that because emerging markets are going through an ‘awesome’ secular trend then this lends them to ETFs: if the secular trend is stronger than the cyclical one then a passive stance is better, while if the reverse is true, then it is better to have an active stockpicking approach. Market conditions in favour of owning ETFs are likely to change only slowly over several years, he said.

Cost efficiency
Low cost is arguably the single most attractive feature of ETFs. BGI reports that the average total expense ratio for equity ETFs in Europe now stands at 37 basis points per annum – some way below the average TER of 87 basis points for equity index tracking funds and 175 basis points for active equity funds across the continent. This is an advantage for ETFs in any equity market, of course, but the high costs of trading in emerging markets can make ETFs a particularly cost-effective way to invest. If an investor decides to take the index tracking route, then the reliability of ETFs means that they are clearly advantageous because they have such low tracking errors against their benchmarks. Given liquidity problems tend to be more prevalent in emerging markets then a low tracking error gives ETFs a clear advantage over other types of funds, even tracker OEICs, SICAVs or unit trusts.

Such a wide choice of ETFs is now available that investors can have access to emerging countries. This has less relevance for retail investors but is a useful attribute for institutions, with large amounts to invest. Many global emerging market products with established track records rarely offer this single country access and if institutional investors like a particular country story then the chances are increasing that they can get that through ETFs.

Finally, ETFs are transparent and highly liquid. Investors can see the performance of an index and know how their investment is doing. Emerging markets are not noted for their transparency and liquidity, so these are reassuring qualities for investors. What is more, ETFs are listed on mainstream markets, such as the London Stock Exchange, with prices available in real-time, so investors can get in and out of the market any time of the day at a price very close to net asset value. This contrasts with mutual funds, which can only offer one price per day and because they tend not to be traded very often they can therefore have wide spreads.

Despite the growing popularity of emerging market ETFs, investors still tend to have underweight exposure to them generally. For example, when Lyxor launched its first emerging market ETFs into the UK in 2007, our analysis of data from the Investment Management Association covering the preceding five years showed that the total amount invested in UK retail and institutional funds in the global emerging markets sector had risen from just one percent to 1.6 percent, while exposure to the Far East ex Japan sector increased from just three percent to 3.6 percent.

Yet these results were in sharp contrast to research that we also carried out to assess sentiment towards emerging markets among UK independent intermediaries. In a survey of IFAs earlier that year, we found that nearly half (46 percent) of respondents recommended that investors should allocate between five and ten percent of their portfolios to emerging markets and 73 percent said that investors needed to increase their exposure to emerging markets. Anecdotally, we would say that a similar situation can be found among investors and advisers across Europe, where investors are clearly sold on the message of emerging markets, yet still have yet to align their portfolios accordingly.

The main reason cited among the IFAs we asked for this apparent mismatch was a lack of emerging market accessibility. ETFs, and Lyxor ETFs in particular, aim to help investors close this gap and help them improve the performances of their portfolios by providing cost effective solutions to some of the world’s fastest growing economies.

It would seem that improving investor sentiment is bound to lead to increasing allocations to emerging markets in their portfolios going forward. The increasing prevalence and choice of ETFs means that it will be hard for investors to ignore them. Hopefully, as investors and advisers increase their understanding of ETFs and grow to appreciate the benefits they offer, much of the increase in emerging market investment will find its way into ETFs. By using ETFs, investors can harness a whole new range of investment strategies both efficiently and cost-effectively.

The growing popularity of emerging markets and the use of ETFs to access them can be seen from Lyxor’s own ETF data. The number of shares outstanding in Lyxor’s leading emerging market ETFs collectively increased by 86 percent over the twelve months ending June 30, 2009, especially impressive considering the extreme levels of volatility in these markets over the same time period.

To paraphrase a quote from the film Casablanca, emerging markets and ETFs appear to be at the beginning of a beautiful friendship.


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