ETFs making emerging markets vulnerable to sudden outflows: Citi

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

After attracting almost $47 billion 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-ization” 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 $244 billion invested in emerging-market ETFs is about 19 percent of the total invested in emerging-market mutual funds, according to Citi.

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 percent of the tradable market in stocks, sovereign credit and local currency.

Dai also estimates that up to 25 percent 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.