Emerging Market ETFs: Back On The Agenda?

Advisers should think outside the box when it comes to developing countries  

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Reviewed by: Emma Smith
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Edited by: Emma Smith

In spite of the dazzle of potentially high returns, emerging markets have endured a rocky ride over the past few months.

Volatility shot up after China’s stock market plunge in August sent shockwaves reverberating through global equity markets. Investors sold off in droves as risk-aversion set in. The fall in commodity prices over the past year has also pummelled emerging market currencies.

But for some investors, the turmoil has created an entry point to buy in, albeit tentatively dipping a toe back into choppy waters.

“Emerging markets are trading on attractive valuations relative to other equity markets and historically,” said Ben Willis, head of research at Whitechurch Securities.

ETFs Are A Low Cost Way To Gain Access

 

“ETFs can provide an efficient way to gain exposure to these markets and in a number of ways too,” said Willis, pointing to the broad flagship MSCI Emerging Market ETFs and those ETFs tracking sectors, themes or individual countries.

While current valuations might provide a timely entry point for long-term investors, the range of ETFs emerging can be flummoxing. The broad MSCI Emerging Markets index is a suitable first base, Willis said.

“The beauty of using ETFs is their flexibility and investment choice and the option is there for investors to build up their own emerging market equity portfolio if they decide that they want exposure to specific countries only,” he added.

Low Cost Is Key

One of the big advantages of ETFs over an actively managed fund is cost. Generally, ETFs provide an efficient low-fee way of accessing emerging market equity markets. The Vanguard FTSE Emerging Markets UCITS ETF has an expense ratio of only 0.15 percent, which it claims is 90 percent lower than the average cost of funds with similar holdings.

However, bid-offer spreads can vary and can widen during tumultuous market periods.

 

Considering Active Management

Another potential issue arises in newer, untapped sectors.

“In less efficient, thinner markets ETFs work less well,” said Ben Seager-Scott, director of investment strategy at Tilney Bestinvest. “They’re less ideal for niche parts of emerging markets. That said, these markets have come a long way, and there’s a lot more liquidity.”

The indexes underlying emerging markets tend to be less efficient than those in developed markets, as constituent stocks are under-researched by comparison, Seager-Scott said.

“This means that there is the potential for an information advantage from a well-resourced active manager,” he said. “There are lots of companies out there, but there are not as many people looking at them.”

Buy And Hold

But this is another reason why investors must brace themselves for a rocky ride. One of the key issues when markets plunge is liquidity. Any increase in investors’ risk-aversion could prompt a large withdrawal of capital from emerging market equities, which causes a sharp sell-off.

Aside from the underlying equities or bonds, currencies can add another source of risk and return. Seager-Scott said emerging markets emerging market currencies have been particularly volatile, adding that currency risk is “very difficult to mitigate”.

Investors tracking a broad based index or a single country index will “follow it down regardless”, Willis warned.

Getting out at the right price can be tough in such scenarios and, particularly in niche areas, can leave investors facing problems when trying to sell. As freely-traded vehicles, ETFs are more liquid than other types of fund, but might still come under strain.

With the threat of volatility still lingering, investing into emerging markets is not for the faint-hearted. But in a world of rock-bottom interest rates and with the need to diversify, investors continue to laud the growing array of ETFs targeting areas which, for many, have previously been inaccessible.