Citi says emerging markets increasingly reliant on ETF flows

MOSCOW: Add Citigroup Inc to the list of analysts and investors concerned by the bumper inflows into emerging-market ETFs this year.

After attracting almost US$47bil of new cash so far this year, exchange-traded funds have made developing nations more vulnerable to sudden outflows, Citi analysts Luis Costa and Toller Hao said in a research report published this week.

The “ETF-isation” of emerging markets has “made ETF flows themselves increasingly representative of asset class sentiment as a whole,” the note said.

“If the tide turns, this strong positive directionality towards passive investments and ETFs can turn into a negative directionality.”

The analysts’ unease echoes similar warnings from Bank of America Merrill Lynch and Schroder Investment Management, which cautioned last month that a pullback from emerging markets similar to the “Taper Tantrum” of 2013 would be exacerbated by the increased share of ETFs in the market.

The US$244bil invested in emerging-market ETFs is about 19% of the total invested in emerging-market mutual funds, according to Citi.

Investors have pulled US$277mil from ETFs that track emerging markets in the past week, according to data compiled by Bloomberg, and a BlackRock fund that tracks local-currency bonds posted its biggest outflow since November on Tuesday after total assets breached US$7bil for the first time.

Morgan Stanley analyst Min Dai disputed the concerns in a research note published last month, saying that ETFs are still a small proportion of the total invested in emerging markets.

He estimates the funds account for less than 5% of the tradable market in stocks, sovereign credit and local currency.

Dai also estimates that up to 25% of the investments in the funds is owned by institutional investors, especially cross-asset funds. Those investors are using ETFs to gain exposure to developing nations and typically take a long-term approach to asset allocation, suggesting a rapid sell-off is unlikely.

Still, Costa and Hao said that ETFs and other passive funds had grown in popularity against more active managers, thanks in part to a long spell of low yields and volatility.

“In a very paradoxical way, not all kinds of investors benefit from long lasting periods of risk compression,” they said. — Bloomberg