Investors have returned to emerging markets via exchange-traded funds (ETFs) following the selloff last year.

The emerging markets ETFs space have reached $190 billion in assets under management (AUM), according to ETFdb. Passive strategies and emerging markets ETFs have also rallied since the beginning of the year alongside traditional benchmarks. iShares MSCI Emerging Markets ETF, for example, had risen 13.82% this year as of April 17, while ETFs tracking the S&P 500 would have benefited from the US index gaining 15.96% over the same time period. 

But emerging market ETFs can potentially be a pressure point for these markets if investors suddenly pull back for exits and trigger a sharp outflow – something that's quite likely given that many institutional investors and large fund managers use employ passive strategies for short-term tactical manoeuvres.

On April 10 the Financial Times reported the IMF had flagged the “destabilising effect” of ETFs on emerging markets, because benchmark-driven investments are “highly sensitive to global factors” that impact these markets. The multilateral agency said outflows from emerging markets driven by a US interest rate shock could jump almost six fold to $11.5 billion, from $2 billion in 2013.

The effect could be profound for countries that are both generally more volatile and possess a high weighting in global indixes. A key example is China, which has its A-shares and domestic bonds are included in MSCI Emerging Markets index and Bloomberg Barclays bond index, respectively. The Shanghai Composite Index suffered a 24.6% plunge in returns at the end of 2018, and is yet to climb back to its historical high in mid-2015.

For investors in emerging markets ETFs this leaves two questions: how much could they be affected by potential macroeconomic volatility, and what can they do to mitigate such risks?

AsianInvestor asked four industry professionals to share their thoughts.

The following extracts have been edited for brevity and clarity.

Joe Marsh also contributed one of the market views below.

Ross Teverson, head of strategy for emerging markets
Jupiter Asset Management

During the course of 2018 we saw prolonged periods when money flowed into passive emerging market strategies and out of active emerging market strategies. This divergence in fund flows can result in equity markets becoming less efficient and failing to value company appropriately, as large index constituents benefit from indiscriminate buying, while smaller index constituents and non-index constituents risk being overlooked.

We believe this was the case in 2018, where companies outside the benchmark became even more overlooked due to investor concentration in indices. This created opportunities to buy into companies with good prospects at low valuations, many of which have rebounded strongly so far in 2019.

Ross Teverson_head of Strategy, emerging markets_Jupiter Asset Management
Ross Teverson

Investors who look to minimise short-term costs by investing passively may find that the long-term cost of doing so is that they miss out on attractive opportunities in certain mid and small cap companies to which they are getting little or no exposure to in a passive strategy. 

Passive strategies could also prove to be more vulnerable in some market scenarios, such as periods characterised by a reversal in passive flows; the rerating of many large caps that has been supported by passive buying could equally be undone by passive selling.

We believe that long term investors will benefit from being diversified across the market cap spectrum and not only exposed to passive funds where exposure is heavily skewed to large cap companies.

Kevin Snowball, chief executive
PXP Asset Management (Ho Chi Minh City)
 
While I agree with the IMF that big, sudden ETF-driven outflows from emerging markets can cause problems and harmful volatility, that’s not so far been the case in Vietnam.
 
The three main Vietnam ETFs [managed by DWS, Van Eck and VietFund Management] conduct public quarterly reviews, so the local players know in advance when the rebalancing day is for each fund and which stocks will be going in and out, or increasing or reducing weightings. This means participants know there is going to be a big buyer or seller of stock A, B or C, and they can prepare themselves to take advantage of that in the closing 15-minute session of the rebalancing day. This has the effect of limiting volatility since large one-way, one-session orders can be accommodated in expectation of a reversal the following day.
 
Historically execution costs were fairly high for the original Vietnam ETFs, as flows were known in advance on a daily basis, with front-running creating a drag on performance. But this [situation] was changed to post-trade reporting several years ago.
 
A bigger cause of volatility in Vietnamese stocks is the fact that index futures on the VN30 are dominated by a few players who tend to use the futures to determine market direction. If the market is strong in the morning, they will sell the futures and then sell stock to push the index down to be able to close their positions.
 
But ultimately, as the Vietnam market has grown, in particular through listing larger stocks with more foreign availability, so the ETFs have been able to better reflect the broader market and have attracted renewed flows as performance has improved. That in turn has contributed to the expansion of the market. So far they haven’t been harmful in any way, as these products have in some markets.

Mark Hui, head of global equity beta solutions for Asia ex-Japan
State Street Global Advisors

Alpha-generation continues to be challenging. A global shift from active to index investing has been on-going as investors continue to look for more cost-effective and transparent investment solutions. With growing demand, index investing has been evolved from traditional cap-weighted index strategy, which is often large-cap biased or sector/country concentrated. 

Given that emerging markets are very sensitive to market downturn, such concentration could have a bigger impact on these markets compared to developed markets.

Mark Hui_head of Global Equity Beta Solutions for Asia ex-Japan_State Street Global Advisors
Mark Hui

However, there has been a lot of innovation around passive investing in the past few years. Passive investors are moving away from traditional cap-weighted indices towards smart beta. For example, a minimum volatility smart beta strategy which tilts towards lower risk stocks can potentially help investors reduce portfolio volatility; a multi-factor strategy combines two or more factors can help mitigate risk arising from concentration to a single sector or country. 

With more index solutions available for investors, it is important for them to understand the features of the investment product such as the breakdown of its underlying benchmark. A concentrated sector or country strategy might not necessary be a bad investment if one understands and is comfortable taking the risks. 

Bonn Liu, head of financial services, head of asset management for Asia Pacific 
KPMG Hong Kong

ETFs are an effective and cost efficient way for investors to get exposure to markets that they may not readily be able to directly either through lack of experience or restrictions.

Bonn Liu_Head of Financial Services KPMG Hong Kong and Head of Asset Management- ASPAC
Bonn Liu

While ETFs can be used to trade a particular market they are also an effective tool for investors to obtain general exposure to a market and this can be for long or short term.  The increased inclusion of certain emerging markets, for example China, in global indexes will mean greater pools of capital going to those markets and ETFs are an efficient way for global investors to obtain the appropriate exposure as they may not have historically covered the market in depth or direct access may be difficult or expensive. 

Additional liquidity may introduce short term volatility but this should even out in the longer term as coverage of these markets increases and investors become more experienced with these markets. The additional liquidity and interest from passive investment strategies can accelerate the development of emerging markets as this will create increased coverage and research and potentially strengthen relevant exchanges as a platform for raising capital for corporates.