Emerging-market exchange-traded funds (ETFs) have been a huge success story. The two largest funds in Europe, which track the MSCI Emerging Markets index (from iShares and db x-trackers), now command nearly $6bn each in assets.
In the short term this boom may have reached its peak. Investors are now very bullish on emerging markets, often a warning that things are about to reverse. The vast volumes of fund flows also suggest you should be cautious. But in the long run, emerging markets are likely to become ever more popular with investors. However, if you plan to invest via an ETF, you should be aware that there are certain challenges faced by indexing in emerging markets that you might not get with a more developed market.
First, emerging markets may have barriers to the free flow of capital. China has long-standing quotas on foreign portfolio investment, for example. Meanwhile, Brazil and Thailand have recently imposed taxes on inflows of cash from abroad, while other countries are under pressure to consider a similar move. Such capital controls are likely to cause tracker funds to trade from time to time at a significant premium or discount from their net asset value (NAV, the value of the underlying index), something indexed portfolios are not supposed to do. For example, ETFs on Brazilian share indices moved to a 2% premium over NAV last year after the foreign financial investment tax was imposed. In Hong Kong, the iShares FTSE/Xinhua A 50 China fund, which gives investors access to domestic China ‘A’ shares via the use of derivatives, traded with a premium of 12% to NAV at one point this year.
Second, there can be a big difference between the performance of emerging-market shares listed on domestic markets and those listed in ‘global depositary receipt’ form on foreign exchanges. Complicating things, indices may track domestic shares while the ETFs attempting to track them buy the foreign versions. In one case last year, the domestic shares of Russian savings bank Sberbank hugely outperformed the Frankfurt-listed Sberbank GDR. The result? A significant tracking error by any fund owning the GDR. So just be extra careful before buying ETFs on emerging markets – check the tracking performance before you buy. Actively managed funds may not be a panacea, but you can’t assume your ‘passive’ fund will always neatly follow its benchmark.
• Paul Amery edits
www.indexuniverse.eu