Efficient Access To Emerging Markets; The ETF Conundrum
By Jesse Sherman, Portfolio Manager, RenAsset Management.
The debate over the most efficient way to access emerging markets has intensified with the development and diversification of ETFs. The ETF value proposition is to provide easy and cost effective access for investors to a specific asset class, sector and/or geographies. While we do not dispute that ETFs provide an easy and low cost solution, the question remains whether the basket is attractive when applied to emerging markets. ETFs for emerging markets remain inefficient relative to actively managed funds due to existing structural issues, which could potentially ease but only over the long term.
Since the first ETF was launched in the early 1990s the industry has experienced phenomenal growth to over $2 trillion in assets as the product offering has evolved, providing access to significant portions of global markets and increasingly specific geographies and segments. The push of ETFs into emerging markets has sparked similar growth, with ETFs now over $330 billion in assets and representing 25% of EM Equity Assets Under Management (AUM) and 7% of EM Bond AUM based on JP Morgan data. The key structural issue for emerging markets is that liquidity is scarce and as such emerging market ETFs, in order to have mass appeal, are liquidity seeking, resulting in more concentrated benchmarks and potentially lower sectoral or geographic diversification.
Emerging markets, due to their earlier stage of market development, tend to be market cap and liquidity dominated by larger state and former state enterprises. Indices which are often created using market capitalisation and liquidity metrics are primarily constituted of these lower quality or less interesting investment opportunities . Often this means ETFs capture a smaller portion or miss completely the more interesting sectors under development and growth. In contrast active managers have the opportunity to sift through a broader investment universe and therefore potentially capture the returns from the more attractive segments of these markets. As a result diversification can become a serious issue for ETFs, for example the MSCI Russia 10/40 index has reduced to just over 20 securities from over 30 a few years ago and there are current concerns that Saudi Arabia if included in Frontier indices would likely comprise over 60% of the index.
One of the disclaimers often mentioned on ETFs is that performance can differ from the underlying markets that it is attempting to replicate, even when it is physical holding, because the ETF might have differences in holding weights; often because of liquidity constraints. Even when you compare ETF performance to the underlying market it is replicating, you see dramatic differences in performance. The Egyptian, Greek and Turkish ETFs have already underperformed the markets by over 12% in their short histories, while the Indonesian, Argentine and Taiwanese ETFs are already over 65% behind their respective indices. While ease of investment cannot be disputed, the performance differential is stark.
Emerging Markets are economies with relatively low income per capita facing rapid market development, regulatory change and growth. In such a dynamic environment active management is able to add value through identifying not necessarily the biggest businesses, but rather those which will evolve and exploit the every changing environment best. Active managers are able to add value through the hands on fundamental research approach spent meeting management teams, understanding their business models and strategy which can deliver superior levels of growth and profitability over the medium term. This is in contrast with Indices and ETFs which by definition are more limited to current liquidity and market capitalisation. An example of this dynamic is Magnit in Russia, absent for a long time from indices, which has seen its revenue increase over 7x and earnings rise nearly 20x since 2006 and gone from an off benchmark stock to up to a 9% weighting in major indices currently.
As emerging markets evolve the market depth and liquidity should continue to improve, but in our view this will be a gradual trend which means active strategies should continue to provide a better efficiency in accessing emerging markets than that of ETFs. As fundamental investors, we focus on cash flow generating businesses with minority alignment and solid corporate governance within our strategies which we believe can deliver sustainable growth, profitability and returns. While these companies are not always exclusively non-state enterprises, the majority tend to be and often are largely under represented or non-existent from benchmarks. ETFs in our view are efficient only in markets where the depth and liquidity extends deep into the small and midcap universe which today remains a largely developed market phenomena. In the absence of this investors are better served to seek out the leading actively managed funds in order to maximise the efficiency of their investment.