ETF Spotlight

Scariest part of emerging markets panic for individual investors: They may be the last to sell

Key Points
  • Emerging markets are in decline, led by steep stock market and currency drops in Turkey and Argentina, but emerging markets ETF flows remain strong.
  • The iShares Core MSCI Emerging Markets ETF (IEMG) is the second-strongest ETF this quarter by flows, and the largest emerging markets bond ETF also has taken in over $1 billion this quarter.
  • The stickiness of emerging markets assets at a time of market volatility suggests that long-term investors aren't running scared, or they just haven't run scared yet and the worst in outflows is yet to come.

Emerging markets are in free fall, led by currency declines in Turkey and Argentina and mounting fears that years of buying up cheap dollar-based debt after the financial crisis has created an unsustainable debt-repayment cycle. But there's one thing the emerging markets have yet to take down with them: investors.

As losses have mounted for funds tracking the MSCI Emerging Markets Index — which was down another 1 percent in trading on Wednesday and has been in decline throughout 2018 — investors have been adding to emerging markets positions.

People walk past a currency-exchange board showing the U.S. dollar and euro rates against the Turkish lira in Istanbul.
Chris McGrath | Getty Images News | Getty Images

The iShares Core Emerging Markets ETF (IEMG) was the fourth most popular ETF in August, taking in over $1.5 billion in assets, according to a new monthly ETF flows report from FactSet Research Systems. Among the biggest losers in August among all ETFs, there isn't a single broad emerging markets stock or bond fund. The iShares MSCI Brazil ETF (EWZ) did see outflows of $752 million in August, the fifth worst among all ETFs, and other single-country funds tracking markets in Russia, Argentina and Turkey have seen net outflows this year. But the contagion fear is not represented by the broader EM flow figures.

One scary way to interpret the numbers: The worst may be yet to come

There are two ways to view the surprising stickiness of assets in emerging markets funds: Investors are sticking to the long-term investing mantra and know that emerging markets will go through periods of volatility, or the worst is yet to come. Because investors have not bailed on emerging markets positions — and it has been a popular trade this year, second only to the iShares Core MSCI EAFE ETF (IEFA) among all ETFs, with $10.7 billion in new assets — the exodus could still be in the making, a position that has been taken by several investment shops that are expecting the panic to hit more broadly. The number of days from peak to trough in the current EM selloff is a longer period of decline than any for the asset class since the financial crisis, including the taper tantrum of 2013, when fears of Federal Reserve post-crisis policy change spooked investors.

Even emerging markets bond funds are proving resilient, with the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) taking in over $1 billion this quarter.

"That is a surprise," said Nick Colas, co-founder of DataTrek Research. He said that retail investors may be holding on to EM bonds because the payouts remain high, and a time when the search for yield has led investors to riskier assets. While EMB is down roughly 6 percent this year on a price basis, it is yielding 4.7 percent. EMB has not cut its payout (44 cents paid on 8/1). "In my experience, retail investors generally do not sell fixed-income funds until payouts get cut. Capital gain/loss is less important to them. We'll see if that holds true with further losses," Colas said.

There is reason to worry. Even though most developing countries are not as fragile as Turkey and Argentina, the dollar this year has risen against all major emerging markets currencies, except the Mexican peso, and the trend may continue with the booming U.S. economy and rising interest rates in the United States, according to Neena Mishra, director of ETF research at Zacks Investment Research.

"Most advisors recommend some allocation to emerging markets in core portfolios, and so we may not see a big exodus from broad EM ETFs. Countries that accumulated too much dollar-denominated debt remain most vulnerable in the shorter term, but investors remain positive on the long-term growth story of the group," Mishra said.

Kevin Caron talks emerging markets

Many assets in emerging markets ETFs are placed by financial advisors and represent only a small — typically less than 10 percent — part of a client's overall equity allocation. Financial advisors making long-term allocations for clients aren't about to run.

"I'm not going to move one way or another over this," said Douglas Boneparth, president and founder of Bone Fide Wealth and a member of the CNBC Digital Financial Advisor Council. "A big portion of the market won't move one way or another," he said.

Colas said many U.S. investors simply may be ignoring the portfolio details. With the S&P 500 and Russell 2000 up significantly on the year, portfolios appear to be doing fine, and there is less pressure to sell, both for self-directed and professionally managed money.

The iShares Core MSCI Emerging Markets ETF has taken in $2.7 billion assets so far this quarter, according to data. There is a wildcard in that figure, which needs to be explained, though. iShares launched the Core MSCI ETF with a lower fee than its existing iShares MSCI Emerging Markets ETF (EEM), and that ETF has seen outflows of $5 billion this year as investors move assets from the higher-cost ETF to the lower one. But it's not a risk-off outflow; it's a cost savings. "It is a large fee spread between the two," Colas said.

The EM trade vs. buy debate

A swing factor that could be keeping EM flows up is opportunistic traders. There is a school of thought that the only way to make money in emerging markets is by trading, not investing. Critics of the long-term buy-and-hold EM philosophy will point to the fact that over the past decade, the MSCI Emerging Markets Index has produced nothing for investors. That argument can be flipped by the fact that emerging markets are by nature more volatile than developed markets, and over the past 15 years EM has produced double-digit returns.

Colas said in a recent research note that the EM index doubled in two years after its 2009 lows, and from the start of 2016 to January 2018, it rose by just over 60 percent. That led him to the conclusion that EM works best as a trade — for investors willing to consider a one- to two-year period as a trade — "when the global economy is either recovering from a crisis (2009–2011) or set to accelerate (2016–early 2018). Otherwise, they can be frustrating "economy of the future" investments.

The trade vs. buy debate is far from decided, and one ETF flows figure that stands out this year is the iShares MSCI Turkey ETF (TUR). Turkey, which precipitated current fears of an EM contagion, has positive flows this quarter of over $200 million and is positive for the year, even as the Turkey ETF is down 34 percent this quarter and over 50 percent this year. For the year, the MSCI Emerging Markets Index is down about 9 percent and the FTSE Emerging Markets Index is down about 10 percent.

There may be at least one sign that self-directed investors are more skittish, at least on the margins. While the iShares main EM stock ETF has seen continued strong flows, the Vanguard FTSE Emerging Markets ETF (VWO) has experienced outflows of near-$600 million in this quarter. "Many advisors use iShares core ETFs as building blocks, whereas Vanguard remains very popular among 'do-it-yourself' investors," Mishra said.

The MSCI EM index has also done better than the FTSE index used by Vanguard. Since the start of 2017, VWO has gained about 20 percent,whereas IEMG and EEM are up more than 25 percent, according to Zacks.

Over the past month, all three have gained assets (though minuscule for VWO), but suggests that maybe longer-term focused investors are willing to step in and buy the dip now.

Boneparth said there is ultimately only one way to test the theory that long-term investors are proving to be wise and will stick to their guns. "I hope that doesn't happen," he said.