You must have watched on television or read in the papers as to how emerging market ETFs have been driving flows into India. Have you wondered what are these emerging market ETFs and what role do they play in a country like India? Let us first look at the concept of an emerging market ETF and some of its pros and cons.
What exactly is an emerging market ETF?
An emerging market ETF is a passive exchange-traded fund (ETF) that focuses on the stocks of emerging market economies. Emerging markets are distinct from developed economies like North America, Western Europe, and Japan. Emerging markets are high growth plus high-risk economies and include Latin America, Asia, and Eastern Europe. Typically, these emerging market ETFs track an underlying index. Globally, MSCI and FTSE are the two largest providers of indices to these emerging market ETFs. In short, ETFs should be passively managed and contain equities from multiple emerging economies.
Emerging market ETFs are comprised of emerging market stocks, which can offer compelling growth opportunities over time for investors. Many investors with longer time horizons simply cannot afford to miss out on the higher returns offered by emerging market economies. India, Taiwan, and South Korea have been some of the preferred emerging markets for global investors and these ETFs are extremely popular among global investors.
Pros and cons of investing in emerging market ETFs
Emerging market investing (even via ETFs) is hardly an unmixed blessing. Investing in emerging market ETFs provide salivating opportunities for investors but come with a steep learning curve and inherent risks. Emerging market stocks are known to follow opaque accounting standards and corporate governance standards can be lax. That is where an ETF can be a better choice. With an emerging market ETF, an investor can target a specific portion of an emerging market based on regional preferences or a specific asset class.
Global investors typically value the diversification benefits of emerging market ETFs in addition to their ability to generate a return. Of course, currency risk is there but that is the reason these global investors prefer economies like Taiwan, Korea, and India where the currency is relatively stable. That is in contrast to Latin America where currencies tend to be very volatile. Also, emerging market ETFs tend to be less correlated to U.S. equities than other ETFs and hence offer a natural hedge. Emerging market ETFs also address the risk of illiquidity in buying and selling individual stocks. As an additional point, investors must be familiar with potential risks before investing in emerging markets. These markets are often more prone to volatility than their more developed counterparts. Emerging markets tend to be overly vulnerable to geopolitical and governance risks. Also, expense ratios for emerging market ETFs are relatively higher than other global ETFs. Despite these challenges, emerging market ETFs continue to elicit interest.
Emerging market ETF flows pick up from October 2019
Chart Source: Bloomberg
For the week ending December 13th, the inflow at $1.15 billion was nearly 8 times that of the previous week. More importantly, this was the 10th straight week of inflows and that is the longest continuous stream in the year. As can be seen from the above chart, the flows have been negative through most of the year with the turnaround inflows only happening post-October this year.
Flows into emerging markets were led by the 3 biggest emerging-market equities ETFs, signaling investor optimism on emerging market equity as an asset class. The $28.7 billion iShares MSCI Emerging Markets ETF received $533 million while the $66 billion Vanguard FTSE Emerging Markets ETF got $352 million. So far this year, net inflows to stocks and bond ETFs added up to $6.81 billion with most of the positive flows coming post-October.
EM ETF rally was driven by the US-China trade deal hopes
Emerging-market assets rallied on optimism that the world’s two largest economies (China and the US) would reach a deal to avert new U.S. tariffs on Chinese goods. The MSCI Emerging Markets Index closed up 3.6 percent from the previous week; the highest level since April 23rd this year. Eventually, China and the US did ultimately reach an agreement; in the process of lifting appetite for riskier assets. Inflows to emerging-market stock and bond exchange-traded funds accelerated as the U.S. and China finally agreed on a phase-one trade deal. To give you an example; Stock ETFs expanded by $1.21 billion while Total assets rose to $274 billion from $265.3 billion. Emerging ETFs have certainly been the flavor of the season and that is good news for Indian markets.