Should we blame the emerging markets sell-off on ETFs?

Some argue the developing world is falling victim to short-term thinking and speculation.

February 11, 2014

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560968_fire_exitIt’s getting ugly in the emerging market space—but no one is 100% clear why.

Some think investors are heeding the call of the U.S. Federal Reserve and bringing their money back to developed markets. Or it could be that investors have long memories and can’t shake their Asian flu nightmares.

Whatever it is, they’ve been yanking money in droves—in January alone, $12.2 billion flowed out of emerging market equities funds, with the sell-off gaining momentum during the last week of the month. Even veteran emerging markets champion Mark Mobius is worried that the sell-off will deepen in the coming months.

So what gives?

According to this article in the Financial Times, [subscription required] exchange-traded funds (ETFs) are to blame. They’ve ushered in a huge flow of fickle money—and, as ETF investors pull their cash, the developing world is falling victim to short-term thinking and speculation.

It shouldn’t be this way, according to John Authers, who wrote the article. He notes that about $300 billion of the $1.3-trillion emerging market equities universe is ETFs. The flight of capital for no particular reason is worrying and, in his view, it is a direct result of outflows via ETFs.

Writes Authers:

The raw facts are that a remarkable amount of money has been pulled out of EM with indecent haste; and that this was the first emerging market sell-off to be conducted mostly through ETFs.

That kind of short-termism is particularly hard on the developing world, where investors ought to take a buy and hold approach.

Authers notes other problems with emerging market ETFs, including a cap-weighted index methodology that pushes money into the biggest firms and ignores smaller companies. Debt indexes, he notes, also tend to send money to countries with the most debt.

In all, he says, ETFs support the kind of boom and bust cycle that policy-makers in emerging markets have been working to avoid.

Authers’ argument is an interesting one, and it speaks to the kind of tyranny of short-termism a lot of people are worried about.

But can we really blame ETFs? After all, they’ve helped introduce legions of investors to this new and growing region of the world. And ETFs have, for better or for worse, helped to bring capital into these countries and to firmly root these markets in the portfolios of mainstream investors.

Moreover, there’s still lots to love about emerging markets—in fact, some countries are in far better fiscal shape than some developed markets. And the fundamentals for growth are still here—strong demographics and a rising middle class with an appetite for consumption (two things that are sorely lacking in North America and Europe).

Sell-off aside, most emerging markets are now able to weather the tide of inflows and outflows. It’s not ideal, but I don’t think it’s the end of the world for long-term investors.

In my view, blaming ETFs for the current market pain is, well, a bit short-sighted.

What do you think? Should ETF investment in emerging markets be restricted?

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