As investors get more granular about their emerging market investments, the ETF market sees the advent of single-country products. Angele Spiteri Paris reports.

Exchange-traded funds (ETFs) offering investors access to broad-based emerging market indices have been widely successful. But now this appetite is developing into a greater need for single-country exposures as investors aim to use these tools as building blocks for their emerging market allocation.

Vin Bhattacharjee, head of Emea intermediary business at State Street Global Advisors (SSGA), says: “There’s a lot of alpha to be made through allocating between countries in the emerging markets and through underweighting or overweighting one country against another. This is why single-country emerging market country ETFs are becoming more popular and why there is significant scope for growth in this space.”

As investors become more granular in their approach to the emerging markets, it makes sense for ETF providers to make a greater emphasis on their single-country products and for those who don’t have any such products to begin launching them.

John Davies, head of ETF licensing in Europe for Standard & Poor’s Indices, says: “Single-country ETFs seem to be the flavour of the moment. I expect that there will be more single-country vehicles brought to market. In fact, Credit Suisse, iShares and others have launched products in this space.

Dan Draper, head of ETFs at Credit Suisse, says: “Different client segments make top-down, macro decisions and use regional and single-country ETFs as building blocks. Investors are starting to discern more on a country basis, and ETFs are giving them the opportunity to make their selection on that basis.”

Other providers can also bear witness to this increased demand.

Manooj Mistry, head of db x-trackers UK, says: “We are seeing more interest in single-country emerging market ETFs. It started with the Bric [Brazil, Russia, India, China] countries and now we have added markets like Malaysia, Thailand and China A-shares, to our suite of ETF products. The creation of these was a result of both demand and investment research.”

Some firms have already seen demand swinging between their single-country products.

Philip Philippides, head of institutional sales in UK and Ireland at iShares, says: “We’re seeing more selective emerging market country exposure from our talks with clients. China is now beginning to
show momentum among European and US investors. In the beginning of the year we had strong flows into China from Asian investors but those in Europe and the US didn’t favour it. However, in the last few weeks we have seen more flows from this client base come into the China product.”

But, although they’re flagged as the next step in the development by most in the market, the road towards more single-country ETFs is not without potholes.

David Rae, senior portfolio manager at Russell Investments, says: “Once you move away from the broad indices, tracking error, liquidity and cost all become issues. It’s a bit of a case of the chicken-or-egg argument because to get tracking error and cost down and increase liquidity you need a substantial number of assets. But if you have high tracking error and your product is expensive, how are you going to gather those assets in the first place?”

Draper, at Credit Suisse, says: “Liquidity begets liquidity so as people get more comfortable with each country then those markets will become more liquid.” And thus so will the ETFs based on indices within those countries.

Bhattacharjee, at SSGA, says: “There are some complications in offering single-country ETFs as a result of investor restrictions in certain markets. For example, in India and in China you have to be a qualified investor to buy securities in those markets. Which is why you would have to use derivatives to provide such products.”

But not everyone believes that the demand is as pressing as some are making it out to be.

Tim Mitchell, head of specialist funds at Invesco, says: “There is no demand for these [single-country ETFs] yet although their development is inevitable as the ETF market becomes more granular.”

In fact, although interest in single-country products has increased, broad-range exposure is still the main attraction when it comes to emerging market ETFs. Mistry, at db x-trackers, says: “We’re still seeing investors allocating on a broader level. Many are still happy to get broad exposure to the emerging markets.”

Emerging market ETFs have in fact been phenomenally successful. Year-to-date until the third quarter this year, saw emerging market ETFs growing in assets by $47.5bn (€34.2bn), according to data from the global ETF research and implementation strategy team, BlackRock, Bloomberg.

Matthieu Guignard, head of product development at Amundi, says: “ETFs are more than just products competing with existing ones, sometimes they are the only way to access a specific market. They provide access to areas investors would have
difficulty accessing.”

Davies, at S&P, says: “ETFs can be seen as the most cost-effective way of getting exposure to emerging markets.”

Draper, at Credit Suisse, says: “Emerging markets are a great success story for the ETF community, both for institutional and retail investors. They are suitable for investors seeking exposure to markets like China.  ETFs allow investors access to emerging market A-shares in their local time-zone and in their local currency.”

Philippides, at iShares, says: “ETFs are good wrappers that solve operational  issues around access and trading. Also, the ease of going in and out of the vehicles allows investors to change their views on the market.”

One concern around using ETFs for emerging market exposure is that, due to their popularity, the companies in the indices the products are based on could get adversely affected.

Mitchell, at Invesco, says: “The worry is that people buy emerging market ETFs blindly, without considering the valuations of the companies in the index. If money flows into the same set of stocks then the P/E [price to earnings ratio] of those companies goes up and investors in an emerging ETF may end up with a return similar to that of Western or developed world companies.”

But Draper, at Credit Suisse, says: “We have heard some concerns expressed around the fact that people are all buying the same index and the same companies and that there could be speculative elements currently in emerging markets. However, if you consider the relative economic growth rates versus the percentage equity market capitalisation these regions represent, there is still a large disconnect between economic growth and the value represented in equity market capitalisation in emerging markets, which means the growth story is likely still strong.”

Another potential concern around using ETFs to access the emerging markets is the fact that, according to some, tapping into the true economic growth of the region cannot be done through an index.

Rae, at Russell, says: “There is a lot of opportunity to add value through security selection in the emerging markets, but for clients who have a particularly short-term need, ETFs are very useful.”

He says that Russell invests in ETFs in the emerging markets for an Asian client on a long-term horizon and uses the passive vehicles for transition purposes on behalf of UK and European institutions.

Choosing to take the ETF route as opposed the active manager one depends on the investor’s reasons for allocating to emerging markets.

David Chellew, head of market positioning at HSBC, says: “If the client requires index exposure, then ETFs are a popular way to go to achieve market access. If they want alpha, then they need to depend on the skill of investment professionals working in these markets.” He points out that, more often than not, active managers beat the index in emerging markets, but adds: “If our clients want beta options, then we need to make the choice available to them.”

Mitchell, at Invesco, says: “Choosing ETFs depends on why investors are allocating to emerging markets in the first place. If they want access to fast-growing companies and are ready to take a certain amount of risk then they should take the active route. If, on the other hand, they want broad exposure to these high-growth regions then indices are the way to go.”

Currently there are several ETFs offering broad exposure to emerging markets, particularly those on the MSCI Emerging Markets index. Mistry, at db x-trackers, says: “The reason for the large number of MSCI products out there is that pension funds benchmark against it.”

So although some believe ETFs don’t necessarily capture the essence of the emerging markets as an asset class, they provide certain positive elements that cannot be had anywhere else in the market.

Draper says: “ETFs on emerging markets can be appropriate for retail investors looking outside their domestic borders for the first time. ETFs allow them to build a cost-efficient, diversified portfolio.”

Chellew says: “ETFs are good for testing the waters for a scheme looking for an exposure to a market where there is limited variability in the potential results. So a small pension fund may benefit from using ETFs as a way to gain access and/or initial exposure to the emerging markets.

Bhattacharjee, at SSGA, says: “If you want long-term beta exposure to the emerging markets then ETFs are the way to go. Also there aren’t many actively managed products that will offer you certain exposures, like Malaysia and Indonesia, so ETFs gives you access you wouldn’t have otherwise.”

©2011 funs europe



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