Do ETFs Pump Up Emerging Markets?

Kurt Brouwer November 12th, 2009

Jason Zweig asks a very good question in a Wall Street Journal column:

ETFs Causing Bubble in Emerging Markets? (Wall Street Journal, November 10, 2020, Jason Zweig)

U.S. investors have pumped roughly $26 billion into emerging-markets funds so far this year. Of that, $15 billion came in through exchange-traded funds — portfolios that hold every stock in a market benchmark with utterly no regard to price.

…As money pours into the ETFs, they must mechanically match their holdings to those in the emerging-market indexes. That forced buying drives up stock prices, attracting still more new money into the ETFs, spiraling stock prices even higher.

…Consider Brazil. The iShares MSCI Brazil Index ETF has nearly tripled in size over the past 12 months. Now at $10.9 billion in assets, it has vacuumed up $2 billion in new money this year. Fully 38% of the fund is invested in only two firms: oil giant Petrobras and mining company Vale do Rio Doce.

Yikes.  U.S. regulations limit ETFs from huge concentrations in a given emerging market stock, but that limitation is still a matter of perspective because 38% in two stocks seems pretty concentrated. Unfortunately, the nature of many emerging market economies is that there are only a few large, publicly-traded companies in which to invest.  When a country specific ETF or mutual fund gets a flood of new cash, the only practical way to put that money to work quickly is to invest in large companies.

The Wall Street Journal continues:

…Thanks to obscure provisions of the U.S. Internal Revenue Code and the Investment Company Act of 1940, which governs how mutual funds are organized, ETFs can’t allow their assets to become over-concentrated in a handful of holdings. In general, they can’t keep more than 25% of their money in a single stock, and at least half of their assets must be in securities that each account for no more than 5% of total holdings.

Having 25% of an ETF’s entire portfolio in one stock can lead to problems at the fund level too.  Let’s say investors tire of Brazil and want to pull out 25% of the ETF’s assets.  The ETF (or mutual fund) has to sell shares in order to raise cash.  Ideally, the ETF would sell shares across its portfolio, but problems can ensue.

With only two very large holdings that together add up to 40% or 50% of the fund, it’s not practical to raise the 25% cash needed just by selling Vale and Petrobras.  The reason is that the fund’s selling of large amounts of stock would almost certainly put pressure on the share price of those companies, thus hurting the ETF’s net asset value and precipitating more sales of the ETF by rattled investors.

To avoid too much selling pressure on the two main holdings, the ETF might want to raise cash by selling smaller company shares.  Unfortunately, the same problem occurs.  Sales of even modest shares in thinly-traded small company stocks would probably lead to lower prices, leading to a lower NAV, which leads to more selling of ETF shares…You get the idea.

The Wall Street Journal continues:

…So what does all this mean for investors? ETFs probably haven’t caused a bubble, and they might even help a bit to prevent one from forming. But many will remain superconcentrated bets on very risky markets. If you invest in an ETF with most of its assets in a few stocks and think you have made a diversified bet, the real bubble is the one between your own ears.

The answer is that ETFs and mutual funds do not pump up emerging market stock markets all by themselves.  But, they do exacerbate the market mood swings, both on the way up and the way down.

My takeaway from this piece and from my experiences with emerging markets over the past 30 years is that the long-term returns from an investment in emerging markets should be higher than returns from investments in developed economies.  Therefore,  it may make sense for a diversified investor to have a stake in these rapidly-growing economies.

Like shark’s teeth…

However, the boom and bust cycles in emerging economies are far more pronounced too, so you have to patient. Like shark’s teeth, getting in is easy, but getting out unscathed can be more difficult…and more painful.

What the heck is an ETF?

Kurt Brouwer November 11th, 2009

In the media and online we see many references to exchange traded funds or ETFs.  I think many investors consider these as being just like mutual funds.  And, ETFs do have a number of similarities to mutual funds, but there are differences as well.

Let’s take a step back and explore this rather new investment vehicle to figure out how they work.

ETFs are probably best understood in comparison to mutual funds.  Mutual funds have been around for many decades and they are the dominant investment vehicle with over $10 trillion dollars in assets. ETFs are relatively new, with the first one dating back only to 1993.  ETFs have made inroads with investors and they now have a bit over $500 billion in assets.

Mutual Funds

Mutual funds generally have these characteristics:

• Low minimum investment

• Immediate diversification

• Professional management

• Security

• Liquidity

• Audited track records


ETFs are also regulated — like mutual funds — under the Investment Company Act of 1940.  They have similar characteristics to mutual funds as shown above, with some differences.  One difference is that mutual funds are priced once per day at the end of that day’s trading.  The fund totals the value of all fund investments and divides that by the number of shares to get the net asset value (NAV) per share.  All purchases or sales that day are made at the NAV.

ETFs are traded throughout the day on a given stock exchange and they too calculate the per share NAV, but shares trade hands on the exchange at a price determined by buyers and sellers, not the per share NAV.  So, ETFs can trade at a discount or premium to the NAV.

Another difference is the rather complicated internal structure for ETFs.


Source: Investment Company Institute

The Investment Company Institute’s 2009 Factbook describes the structure of an ETF this way:

..An ETF originates with a sponsor, who chooses the investment objective of the ETF. In the case of an index-based ETF, the sponsor chooses both an index and a method of tracking its target index. Index-based ETFs track their target index in one of two ways. A replicate index-based ETF holds every security in the target index because it invests 100 percent of its assets proportionately in all the securities in the target index. A sample index-based ETF does not hold every security in the target index; instead the sponsor chooses a representative sample of securities in the target index in which to invest. Representative sampling is a practical solution for an ETF that has a target index with thousands of securities in it.

…ETFs are required to publish information about their portfolio holdings daily. Each business day, the ETF publishes a “creation basket,” a specific list of names and quantities of securities and/or other assets designed to track the performance of the portfolio as a whole. In the case of an index-based ETF, the creation basket is either a replicate or a sample of the ETF’s portfolio. Actively managed ETFs and certain types of index-based ETFs are required to publish their complete portfolio holdings in addition to their creation basket.

ETF shares are created when an “authorized participant”-typically an institutional investor-deposits the daily creation basket and/or cash with the ETF (Figure 3.3)… Creation units are large blocks of shares that generally range in size from 25,000 to 200,000 shares. The authorized participant can either keep the ETF shares that make up the creation unit or sell all or part of them on a stock exchange. ETF shares are listed on a number of stock exchanges where investors can purchase them as they would shares of a publicly traded company…

If you made it through that riveting prose, you are probably a bit confused.  Don’t feel badly though because it really is confusing.  ETFs have this complex process as part of their structure and I doubt if very many investors fully understand it.  The key takeaway is that ETFs maintain the price of their shares in a different manner than traditional mutual funds. Though there are still questions and concerns about the ETF structure, ETFs seemed to have held up pretty well during last year’s financial crisis, despite the convoluted internal structure.

ETFs have many of the built-in advantages that mutual funds have, but there are also differences such as being traded on an exchange throughout the trading day.  In my view, the biggest difference is not the fact that ETFs trade throughout the day or even how ETF pricing works, but rather that ETFs have a very short operating history and investors are still learning how they function.

ETF assets are growing…


Source: Investment Company Institute 

ETFs are growing as an investment vehicle and they are with us for the long haul.  They fall into three primary categories.  The first category is broad-based ETFs that track a given index such as the S&P 500.  The second major category is more exotic covering ETFs designed to track a very narrow investment sector.  The third major category includes leveraged offerings designed to give investors high octane trading vehicles.

The ICI Mutual Fund Factbook continues:

As demand for ETFs has grown, ETF sponsors have offered more funds with a greater variety of investment objectives. In the mid-1990s, ETF sponsors introduced funds that invested in foreign stock markets. More recently, sponsors have introduced ETFs that invest in particular market sectors, industries, or commodities. At year-end 2008, there were 231 sector and commodity ETFs… While commodity ETFs made up 19 percent of the number of sector and commodity ETFs, they accounted for 38 percent of total assets… Approximately three-quarters of commodity ETF assets tracked the price of gold and silver through the spot and futures markets in 2008. Sector ETFs that have proven to be popular with investors, both in terms of the number offered and assets gathered, are those focused on natural resources and financial institutions…


Source: Investment Company Institute 

We use both mutual funds and ETFs so I am not at all negative about exchange traded funds, but I am aware that there will be growing pains as the ETF industry matures.

For more on ETFs, see also:

Growing Pains at Bond ETFs

INFLATION: Can you protect your portfolio?

Mutual funds on the rebound

Kurt Brouwer November 10th, 2009

Smart Money did a piece on mutual funds that had a rough year in 2008, but were doing well in 2009.  Here’s how they selected funds:

…The Criteria: The funds on the table were in the bottom 20% of their Morningstar categories in 2008. However, in 2009 they’re in the top 20% of those same groups. They are open to new money, require a minimum investment under $5,000 and charge an annual expense ratio less than 1.5%. We favored funds that have histories of doing well in post-recession periods or are run by decent managers. As usual, we did not include load funds.


Source: Smart Money

We have used Dodge & Cox Stock Fund on occasion although not as a core holding.  It is a well-run mutual fund that had a very rough year in 2008.  Other funds on this list such as Vanguard Windsor and Ariel are funds with solid long-term records.

This is a good piece because it illustrates how different things look today than they did early in the year.

State Tax Revenues Plunge

Kurt Brouwer November 10th, 2009

The fact that state tax revenues are falling should not be a surprise given that we have been in a recession.  Nor, should it be surprising that income taxes have fallen far more than sales taxes or property taxes.  Historically, the bulk of income tax revenues come from higher income folks whose income is far more volatile.  This is all predictable, but I imagine this predictable outcome is still quite a shock to the powers that be in our state capitols:


Source: Nelson A. Rockefeller Institute

My prediction?  We will see a lot of interest on the part of politicians for additional sales taxes such as the value-added tax (VAT) as used in Europe.  This would not be so bad if it replaced an existing tax, but that will almost certainly not be the case.  The VAT will be increasingly touted as a way to ‘solve’ the state funding or Federal funding shortfall.

Hat tip: Barry Ritholtz

S&P gains while dollar loses

Kurt Brouwer November 9th, 2009

If you are a U.S. investor, the S&P 500 is up over 20% this year.  Not bad all things considered.  However, investors in other countries have often not fared as well because the gain from U.S. stocks was offset by the decline in the dollar.  This table gives a sense of how that has worked out:


Source: Bespoke

All in all, U.S. stocks have still been good for foreign investors this year, with the exception of a few very strong currencies.  On the other hand, those who have most of their wealth in those strong currencies are probably looking at our stocks, real estate and other assets as bargains.

What’s next for the dollar?

The big difficulty we face now is that the economy is weak and the Fed likes to have low interest rates to help the economy begin to grow again.  Low interest rates are helpful to overall economic activity, but lower rates generally hurt the dollar.  If we wanted to help out the weak dollar, the response would ideally be to raise interest rates.  However, due to serious weakness in the economy, the Fed is hampered in its ability to respond to this situation and I believe it will opt to keep interest rates low for a year or so in order to promote economic growth.

You may hear various members of the Federal Reserve or politicians or pundits decrying the weak dollar.  However, for decades, our government’s philosophy during recessions has been to publicly espouse a strong dollar while, at the same time, cutting interest rates to strengthen the economy and give unemployment a boost.  This has traditionally been done despite the fact that lower interest rates generally lead to a weaker dollar.  I don’t see anything in the cards that appears to have changed that policy.   Therefore, I expect continued pressure on the dollar as the Fed seeks to get economic activity going again.

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