ETFs’ Spurned SOS Signal
As global ETFs totaled $3 trillion according to the latest data and regulators continued to fret in particular over $300 billion in emerging market equity exposure at one-quarter of outstanding mutual funds, the Investment Company Institute representing the industry claimed fears were “exaggerated.” Its chart of EM stock and bond ETF growth the past five years showed they both account for less than one-tenth of capitalization in the respective asset classes and publically-available funds were responsible for just 15 percent of the period’s $1.5 trillion in foreign portfolio flows. It did not quantify hedge fund engagement but argued that sovereign wealth vehicles were the dominant influence.
According to trackers the Vanguard and BlackRock iShare offerings with $75 billion in combined assets were the biggest, and of the ten leading ETFs most are global with the remainder India and Russia-focused. The average expense ratio is just over 0.5 percent, and in Q1 they spurred all but $1 billion of the $12 billion in stock fund outflows across the core and frontier universe categories. Hedge funds drive trading on New York Stock Exchange EM listings at over 10 percent daily turnover. They routinely employ leveraged versions which enable long and short positions double and triple basic commitments. The SEC has warned that such bets, along with “exotic” country ones, are unsuitable for average retail investors and may aggravate liquidity and market-making pressures. During the Federal Reserve taper scare several funds had problems with overnight pricing and redemptions suggesting the need for broader fixes in a sustained selloff.
The BIS in a follow-on report last year noted the additional threat posed by common benchmarking of emerging market assets to a greater degree than in developed economies. This clustering is pronounced with the MSCI and FTSE indices used by 40 percent of ETF launches, which also typically do not offer currency hedges and were thus pounded with the past months’ dollar surge. An array of specialist EM sponsors now promotes company sector and size and intra and sub-regional alternatives, as well as dividend-only and derivative-protected products. Several feature a combination of active and passive management, even though the former have underperformed in recent years. Market Vectors, whose Egypt ETF was closely monitored during President Mubarak’s and Morsi’s overthrows, follows a different definition which taps multinational companies with earnings and operations in the named destination. With this flexible approach a Central Asia and Mongolia construct can be more liquid than the underlying markets.
The bond ETF segment at just over 5 percent of the $350 billion in dedicated funds has not evoked similar alarm, but individual interest has returned to local currency and entered external debt within $10 billion in Q1 allocation. Barclays underscored in recent research that bank market makers under capital and supervisory constraints have turned to them for indirect liquidity, raising the prospect of simultaneous primary and second market collapses. Despite the ICI counterattack, industry and official representatives have started to consider further safeguards that may muffle the next rapid-trigger firing amid actual US interest rate rise echoes.
