Big inflows into emerging-market assets via passive investments such as exchange-traded funds (ETFs) can expose investors to high concentration risk, argues Wylie Tollette, senior vice-president of investment risk at US-based Franklin Templeton.

ETFs are designed to mimic indices in the emerging economies they invest in, and in those markets often a few stocks account for a very large chunk of total market capitalisation and daily index movement, he notes.

“People may believe they are getting significant diversification by heading down the passive route, but they may be buying more of particular names – say, Samsung in Korea – than they anticipate,” says Tollette. “And a lot of that’s been driven by the wall of money that’s gone into emerging markets.”

He admits, however, that the ability of active managers such as Franklin Templeton to diversify away from a market-capitalisation benchmark poses its own risks.

“If flows continue into large caps, we are taking a risk by not being in those positions,” he says, adding that his division is there to demonstrate to portfolio managers the risks of both actions, to ensure that the risks in portfolio are “recognised, rational and have the potential to be rewarded”.

Another issue with ETFs, notes Tollette, is that tracking error between the fund and the index it purports to follow means investors may not get the performance they expect. Tracking error can be fairly significant, he adds, and is often driven either by buying a subset of an index or by using derivatives to mimic it within the ETF portfolio, which may not always be priced in the same way.

There are also counterparty issues when ETF providers use total-return swaps (TRSs) – as opposed to the physical shares – to reproduce index returns, says Tollette.

It's only the handful of large global banks that have the ability to underwrite such swaps in sufficient volume to support ETFs, he says, and if there were sharp outflows, swap counterparties could have major pricing and liquidity issues if they had to unwind large volumes quickly.

Active managers also use TRSs, he concedes, but the difference is that they tend to use them for hedging purposes rather than as the entire or main basis for issuing products.

Asked if these concerns over ETF risks mean that Franklin Templeton is unlikely to consider entering the ETF business itself, Tollette was non-committal.

"We remain committed to our approach of providing actively managed funds designed to enhance shareholder value over the long run, especially considering the risk management oversight we employ as an integral part of our process," he says. "In volatile markets similar to what we have been experiencing, many investors will continue to seek active management with an eye on risk.”   

While Franklin Templeton’s approach to risk management has always been an integral part of its portfolio-management process, what has changed in the past few years is the frequency with which Tollette's division evaluates risk. Where it was quarterly, it has been stepped up to monthly, bi-weekly or even daily in some cases.

For example, the risk composition for fixed-income investments is posted daily for portfolio managers. It involves using risk analytics to look at both asset portfolios as well as their underlying benchmarks, says Tollette. This can help to heighten the team’s awareness of increased debt-market volatility and changes in bond prices and risks before the market picks up on these issues.

Most of the activity in terms of these changes has taken place in the past year, he says. And the benefits of doing it have been reinforced by events of the past year or so, such as the earthquake in Japan in March, the revolutionary wave in the Middle East this year and the BP oil spill in the US last year.

The risk team helps portfolio managers to identify the potential impact of such occurrences. The PMs must then evaluate the short- and long-term effects, and therefore whether or not they will create buying opportunities.