Exchange-traded funds (ETFs) may not be the best way to access small, immature equity markets due to high tracking error and low liquidity, fund managers argued at a conference last week.

“Forget frontier-market ETFs – they don’t replicate the underlying index,” says Terence Mahony, chairman of Vietnamese asset manager VinaCapital. “I think you’ll get ripped apart. You have to be very careful [about frontier markets].”

Strong words perhaps, but ones echoed to some degree by other active fund managers and even an ETF provider during a panel at the ETF and Indexes Investment Summit in Hong Kong last week. They cited illiquidity and low volumes as major problems for ETF issuers in immature economies, and also pointed to their lack of transparency.

ETFs may not reflect the true market performance of frontier markets, says Frank Lin, head of the international business division at Polaris Securities Investment Trust, Taiwan’s leading ETF issuer. Polaris does not offer any frontier-market products. 

The tracking error of physically replicated developed-market ETFs ranges from around 50 to 125 basis points, adds Lin, but for frontier markets it can exceed 500bp due to their illiquidity and related expenses.

Mahony makes a similar point, noting that Van Eck Global’s Vietnam ETF is down 17.08% year-to-date, whereas the stock market is down 9.31%.

As a result of the illiquidity of frontier markets, ETF issuers may well include names not in the index but that supposedly have exposure to the domestic market.

Five of the stocks in the Van Eck product, for example, are related to doing business in Vietnam rather than being part of the index, such as Malaysian construction company Gamuda and Canada’s Talisman Energy, says Mahony. “How much of their business is Vietnam-related? Maybe only 5% or 10% perhaps.” he adds.

Fabian Salvi, director of the client group at Dragon Capital in Ho Chi Minh City, echoes their concerns and raises a number of his own.The Vietnam stock market’s average daily turnover is around $60 million this year, of which foreign participation accounts for some 10%, notes Salvi (pictured below).

“Vietnam is still a new market, with certain constraints,” he adds. “We don’t know how ETFs will react to certain events and to turmoil in a market that can sometimes dry up to just $10 million a day in turnover.”

The illiquidity of frontier markets makes it very difficult to physically replicate their performance via tracker funds, says Salvi.

The panellists also raised the issue of corporate governance. Corporate governance is not generally measured by indices, aside from corporate social responsibility benchmarks. And ETF providers must follow the index unless they conduct sampling to replicate it.

This is a particular issue for frontier markets, whose companies are less likely to follow governance best practice than those in developed economies.

Dragon Capital has always placed a strong focus on corporate governance, says Salvi, given that its main investor base of institutions such as pension funds demand high standards in this area. ETFs cannot do the same, because they follow the market-cap weighting of a given index.

For example, Dragon Capital won’t buy a company that uses child labour, he says, but an ETF must do so if it is in an index.

“One of the three biggest stocks in the Vietnam index is not transparent at all,” adds Salvi. “I would not invest a single cent in it, but the ETFs keep having to buy it, pushing it up to 40x or 50x price-to-earnings.”

“We have about 15 analysts researching companies and can confidently select fundamentally sound stocks in Vietnam that will provide strong growth for good value,” he says. “But those stocks are not necessarily all in the top 10 by market cap in the index.”

All that said, Salvi makes the point that he believes in ETFs, but feels a lot of work has to be done to create or find a suitable index that reflects what foreigners can access in Vietnam.

Others are more positive on frontier-market ETFs. Marco Montanari, Asia head of db X-trackers ETFs and db-X funds at Deutsche Bank, tell AsianInvestor that the tracking error between the ETF’s net asset value and the index is minimal for his firm’s frontier-market products.

For example, the FTSE Vietnam Index fell 28.04% in the year to August 31, while the db X-trackers FTSE Vietnam ETF fell 27.41%. This is to be expected because the product is a swaps-based ETF, which tend to more closely replicate the underlying index returns than do physically replicated (stocks-based) ETFs.

With regard to concerns over transparency, Montanari (who was not on the panel) says it is easy to check the NAV or price of the ETF and compare them with the underlying index.

Meanwhile, he adds, where the price of a frontier-market ETF does not reflect the underlying market, an investor can take advantage by arbitraging the ETF and buying if the price is too low or selling if it is too high.