Emerging markets exchange traded funds (ETFs) have recently experienced massive outflows as some concerned investors have pulled away from these markets. Some fund managers see this as a buying opportunity, arguing that emerging markets now look cheap. So if you want to buy in at what could be a good entry point, is an ETF or actively managed fund better?
"Emerging markets are less well researched and less efficient, so greater opportunities exist for skilled fund managers to deliver consistent outperformance of their benchmarks," argues Slim Feriani, chief executive officer of Advance Emerging Capital, which runs emerging markets fund of funds. "ETFs in emerging markets, on the other hand, can be relatively expensive compared with those in developed markets. This locks in underperformance."
He continues: "The indices that ETFs track are also backward looking and skewed towards the larger more liquid constituents in each market. Thus strong inflows or outflows exacerbate volatility. Active managers are likely to be able to partly offset this volatility by allocating a percentage of their portfolio to non-index stocks."
However, the choice of good active managers has become smaller as two of the leading emerging markets houses - Aberdeen and First State - have closed a number of their funds.
Emerging market ETFs are also cheaper than emerging markets active funds. "The only certainty of investment is that you have to pay something in advance," says Jose Garcia Zarate, senior ETF analyst at Morningstar. "So, it makes sense to ensure the costs that you know that you're going to have to pay are the lowest possible."
"If investors find an active fund they like at the right price they should buy it, but they should bear in mind they are paying a higher price and still run the risk of underperforming the broad index," adds Peter Sleep, senior portfolio manager at Seven Investment Management. "Emerging markets provide many opportunities for portfolio managers to outperform but are volatile and will catch out professional investors from time to time. If investors want a simple, low cost way of investing, an ETF or tracker fund is an excellent way of gaining entry."
This is particularly important for long-term investors, and, given the current volatility, emerging markets are an area you should only invest in if you have a long-term horizon. But if your time-horizon is shorter ETFs also allow you to get in and out fast, which can be useful for trading in volatile markets, and have a relatively high degree of liquidity.
When an open-ended fund experiences large outflows this can be detrimental to investors left in the fund because it is forced to sell assets, usually its most liquid and higher quality ones, negatively affecting performance. But an ETF will continue to replicate the index it tracks in the given proportions and reduce holdings in line with it.
Adam Laird, passive investment manager at Hargreaves Lansdown, also points out that ETFs do not necessarily sell shares to meet redemptions but may swap the holdings with an investment bank which will sell the shares.
Mr Sleep adds that when there are redemptions ETF issuers impose a small charge to ensure the costs are paid by the redeemers and not by those who remain in the fund.
Best emerging markets ETFs
When choosing an ETF, you need to decide on the structure of the fund. Physical funds buy some or all of the assets in the index they track. Synthetic ETFs do not buy the assets but get the return of the index they track via a swap counterparty, usually an investment bank or insurance company, which pays the ETF the returns of the index it is tracking, often in exchange for the returns of a collateral basket held by the ETF. It can be cheaper to set up a swap than buy all the shares in an index and regularly rebalance the ETF's portfolio.
In emerging markets, where individual shares can be less easy to buy and sell, there is an argument for using a synthetic structure; typically physical emerging markets ETFs cost more and don't track their benchmarks quite as well. "If accurate tracking is considered more important, a synthetic ETF will result in performance closer to the actual benchmark," says Dr Feriani. A study by Morningstar found a small difference between the average tracking difference (difference between the ETF's and the index's return) of synthetic and physical emerging markets ETFs: -0.91 and -1.03 per cent, respectively. However, the rare risk with synthetic ETFs is that the swap counterparty defaults, say, because it has become insolvent and is not able to honour its obligation.
Mr Laird recommends the HSBC MSCI Emerging Markets ETF (HMEF) with a 0.6 per cent total expense ratio (TER). "HSBC's ETF range is physically backed and they take a conservative approach to running them - they don't lend stock for example," he says.
Mr Sleep recommends the Vanguard FTSE Emerging Markets UCITS ETF (VFEM). "I think it is unbeatable value at 0.29 per cent: it is physical and tracks far better than its big name rivals," he says. "I do not think that physical or synthetic makes much difference. The counterparty to the swap still has to go out and buy the underlying stocks to hedge their exposure and, in my experience, if they mess up the hedging it gets passed back to the end investor."
Mr Laird also recommends the synthetic Amundi ETF MSCI Emerging Markets (AEEM). "Amundi aren't that well known in the UK but their ETFs are good quality and synthetically replicated, meaning their tracking is very accurate."
