The rise of ETFs is ‘destabilizing’ emerging markets

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The explosive growth of index exchange-traded funds has destabilized emerging economies, increasing their vulnerability to global shocks, according to Italian central bank economists.

Their analysis found that investment funds were much more likely than other private sector sources of finance, such as banks, insurance companies and pension funds, to withdraw funds from developing countries when global shocks.

Additionally, passive index funds are more shock-responsive than actively managed ones, according to the research. In this environment, investment flows to ETFs focused on emerging markets are even more sensitive to global financial conditions than those to equivalent mutual funds, making ETF money the least reliable of all forms. of financing.

“Reliance on investment funds, especially those focused on benchmarks, makes emerging markets more vulnerable to global shocks,” wrote Alessandro Moro and Alessandro Schiavone in their paper “The role of non-bank financial institutions in intermediating capital flows to emerging markets”.

“Empirical evidence points to systemic risks associated with procyclicality, herd behavior and highly correlated asset movements from non-bank financial institutions,” they added.

Reforms enacted in the wake of the global financial crisis forced banks to reduce non-core assets held on their balance sheets, such as emerging market securities. Investment funds have sprung up to fill the void as the low yield environment has led investors to seek higher risk assets.

While greater diversification of funding sources should reduce costs and liquidity risks for recipient countries “on the other hand, the growing role of investment funds has been associated with more volatile capital flows”, the study authors said.

“The Covid-19 crisis, when global financial conditions deteriorated sharply, highlighted the destabilizing role of investment funds for emerging economies. Asset sales by investment funds were the main driver of the sudden stop in emerging markets during the first quarter of 2020,” they added.

The document revealed that the flakiness of wallet flows was not limited to the start of the Covid pandemic but has become the norm. “Redemption pressures are particularly severe for passive funds” during times of global market stress, they found.

Additionally, “the growing popularity of benchmark-based investment funds, including ETFs, may increase the similarity of behavior among asset managers, increasing the potential for one-sided markets and large price swings in Emerging Markets”.

Using data from the IMF, Bank for International Settlements, and portfolio flow data provider EPFR, they found that a one standard deviation increase in the volatility index Vix results in a reduction of 1. 8% of active fund holdings in emerging market bonds, but a 2.3% drop for passive funds. The equivalent figures for equities were 1.2% and 1.5%, respectively.

For ETFs, these numbers increase further to 2.8% for bonds and 1.6% for stocks.

“We speculate that this finding may be due to the fact that passive funds and ETFs investing in emerging assets are subject to more redemption pressures during periods of market turbulence,” the authors said.

This is of growing importance, given that the share of passive funds in fund industry assets has increased from 20% to 30% over the past decade, with the share of ETFs rising from 14% to 21% over the past decade. the same period.

Bar chart of fund holdings, as % of total holdings of all financial intermediaries, average 2015-2020 showing investment fund penetration

“It’s money that can return in no time,” said Charles Robertson, chief economist at Renaissance Capital, an emerging-markets-focused investment bank that specializes in passive investing for investors in detail.

“Retail investors sometimes have a bee in their hood on crypto or gold or US growth stocks and potentially emerging markets. When the confidence is there, they flock in, but it’s an hour of work to sell the ETF and walk away. It is not a reliable source of long-term investment that countries need,” Robertson added.

He cited the example of Egypt’s local currency bond market, which had only $70 million in foreign portfolio investment in 2016. By 2018, that had risen to $70 billion, but “half what remained during the Turkish crisis of mid-2018”. [when a debt and currency crisis erupted in Ankara]. Twelve months later, everything was back.

Moro and Schiavone called on regulators to consider measures to mitigate the impact on financial systems and emerging economies from the growing importance of funds in intermediating capital flows.

“This involves adopting a macroprudential approach in overseeing the asset management industry and enhanced coordination between regulators and international organizations,” they said.

“To address the destabilizing role of investment funds, reforms should be enacted to mitigate the risks associated with redemption pressures, procyclicality and herd behavior.”

Robertson said one possible solution is for emerging countries to impose capital controls, denying the entry of speculative money in the first place and boosting stability by reducing currency and interest rate volatility.

While this is “arguably the right position”, he said, it has its own drawbacks in that the lack of foreign capital probably means “higher interest rates, less capital for the ‘investment and lower growth’, as well as the long-term limitation of foreign investment. direct investments that countries need for economic development.

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