Magazine Issues » September 2018

EXCHANGE-TRADED FUNDS: The autumn harvest

AutumnHistory suggests America’s protectionist stance should be followed by a period of dollar weakening, which could benefit emerging market ETFs – perhaps as soon as September. Nicholas Pratt reports.

Although exchange-traded funds (ETFs) investing in emerging market assets were hit by this year’s volatility as the US dollar strengthened and concerns surfaced about trade wars, inflows into these funds actually paint a positive picture.

According to Morningstar, there were consistent inflows into emerging market ETFs as a whole from early 2016 through to the end of April 2018. During this period, investors globally put almost $100 billion (€88 billion) into emerging market equity ETFs, $15 billion into hard currency bond ETFs, and $12 billion into local currency products. However, recent months have seen a reversal in flows for equity and local currency products. In May and June, emerging market equity ETFs saw $12 billion in outflows, while local currency saw $2 billion of outflows.

Hard currency ETFs, meanwhile, in attracting $1 billion, were beneficiaries of recent unease, which saw the S&P 500 up by 0.62% in June while emerging markets posted losses of 3.40%.

Over the half-year to the end of June, the S&P was up 2.65%, while emerging markets posted losses of 6.05%.

Local currency outflows began in March, became a trend in April and significant in June, says Antoine Lesne, regional head of strategy and research at SPDR ETF. “The implementation of tariffs was getting closer and Donald Trump’s threats to China began to impact equity markets more noticeably. Turkish lira weakness also impacted investor confidence.”

There has been little variation in outflows across emerging market regions, says Chris Mellor, regional head of ETF equity and commodity product management at Invesco. “The flows for region-specific ETFs appear to have largely mirrored those seen for broad EM [emerging market] ETFs.”

More vulnerable
However, if the threat of US-led trade wars is taken as a major source of emerging market volatility, then certain countries will be more vulnerable than others in the short term.

Aneeka Gupta, associate director of research at WisdomTree, examined the bilateral trade balance with the US of the 24 countries on the MSCI Emerging Markets index and found that four countries – Mexico, Colombia, Malaysia and China – are especially exposed.

“Mexico has the highest trade surplus at 6.1%, while China does not have as big a trade surplus but could see 0.3%-0.5% shaved off its GDP if a trade war escalates,” she says.

The emerging market universe does contain potential sources of optimism, however. One is Saudi Arabia. In June, it was announced that MSCI would be adding the kingdom to its emerging market indices next year. Mellor says Invesco has seen “significant interest in this market”. Only two ETFs offer exposure to Saudi. One is in the US; the other is the Invesco MSCI Saudi Arabia Ucits ETF, launched in June. Combined, their assets have grown from $14 million to more than $300 million since the beginning of 2018, says Mellor.

However, others say Saudi Arabia alone is unlikely to cause a significant rebound in emerging market ETF flows. The upgrade to emerging market status has been in discussion for some time and any positive sentiment is likely to be negated by the delay and possible abandonment of the IPO of state-owned oil company Aramco.

Of more importance will be the strength of the US dollar, says Gupta. “We need to see some dollar weakness for there to be any rebound. And we also need to see EU equities doing better. But if trade wars create some distortion, we will see some dollar weakness.

“History suggests that aggressive protectionist actions imposed by the US government over the last 50 years coincided at dollar peaks and were subsequently followed by dollar weakness,” she adds.

With this in mind, should investors still consider a return to emerging market ETFs? The answer is not a straight-forward one, says Lesne at SPDR ETF. “While we may now see some positive trends emerging, many investors reassessed their overweight in June, suggesting it may be too soon to come back. Ultimately a return to former volumes could occur, but this may take time.

Given the seasonal summer lull, we may not see any notable changes in flows until September.”

Factors such as the possibility of trade wars are important, especially with China, says Lesne. Nevertheless, he is positive about the global economy and the fundamentals for emerging market economies.

“Valuations are fair and not too expensive, therefore I would see EM ETFs as a trade for the long term. In the short term, I would encourage investors to be prudent. There are opportunities here for those who are prepared to weather volatility.”

One such opportunity would be within an income strategy, says Lesne. “I would take that exposure and clip higher coupons in both nominal and higher inflation-linked local currency sovereign debt.”

Finally, while Trump’s trade war posturing does create some inevitable volatility for emerging markets, other, more idiosyncratic factors are in play, as seen in Brazil and Turkey. Thankfully, there has been no major cross-correlation between currencies, says Lesne. “The market has focused on specific risks rather than the EM market as a whole and that’s a good thing. However, the caveat is that there are still a number of political uncertainties that could recorrelate at some stage and EM strategies can sometimes be a one-size-fits-all within the ETF market, being bought and sold as a whole rather than on a more granular basis.”

ETF manufacturers retain an optimistic view of the EM universe. “Our view for the coming three months is neutral for global emerging market indices, but for the longer term, looking through to June 2019, the view remains positive,” says Keshava Shastry, head of ETP capital markets at DWS. “For Latin America, our view is neutral for the next one to three months but negative through to June 2019, and for Asia-ex Japan it’s positive for the short term and also for the coming year.”

Another view is that, assuming no serious escalation of political tension and currency movements, 2018 could affirm emerging market ETFs as an asset class.

“When there are periods of volatility, it can be a great testing ground for the ETF model,” says Fran Rodilosso, head of fixed income ETF portfolio management at VanEck. “You see whether they end up trading at a serious discount or have extreme outflows. The majority of EM ETFs stood up to the volatility.”

More importantly, he adds, emerging market ETFs functioned well as an investment tool and a means of beta exposure. “Investors were able to change their positions, so the liquidity story held up. As long as investors understand how an ETF functions and that it can be – but is not necessarily a replacement for – active funds, then I think this year’s events will strengthen the ETF story.”

©2018 funds europe