A Primer on Emerging Market ETFs

 

In many ways investors have never had it so good. Since last week practically the entire U.S. brokerage industry has gone to zero commissions for stock trades. At the same time, the most prominent ETFs (exchange traded funds), which are ideal building blocks for any allocation strategy, are charging minuscule management fees. This means that a millennial investor today can build his wealth without incurring any transaction costs. Compare this baby-boomers  who accumulated savings while paying fees to financial service firms of 1-2% per year on assets.

This gradual disruption of the revenue base of the investment industry has occurred over the past 30 years, through the concurrent rise of discount brokers (e.g. Charles Shwabb) and low cost indexing strategies (initially driven by Vanguard mutual funds and later by ETFs). All of these changes are driven by computer automation and scale. In recent years, the trend has accelerated.  JPMorgan estimates that today 90% of U.S. equity trading volume comes from computer-driven systematic trading accounts, leaving 10% in the hands of discretionary traders.

This disruption in some ways is even more profound in emerging markets where transaction fees have historically been much higher than in developed markets.  ETFs are allowing investors  to largely bypass the high costs of investing in local markets because the great majority of trades can be settled internally within the funds, and only marginal increases/decreases in assets have to be funded externally. (e.g. EWZ, the Ishares Brazil ETF now settles daily within its own structure about the same volume as Brazil’s Bovespa index.) Moreover, emerging market asset managers in the past had been able to charge high management fees, typically in the 1.5-3.0% range, and even today very high fees remain the norm in most domestic markets. However, today any investor can get  broad global emerging market exposure through ETFs for an annual fee of 11 basis point (0.11%) and Franklin Templeton is offering a suite of country funds with annual expenses of 19 basis points (0.19%). When the first country funds where launched in the 1990s they had expense ratios of 2.5-3%.

The result is that emerging markets, like other asset classes, have come to be  dominated by low cost indexed products sold in the form of ETFs  and mutual funds. These funds which are computer driven and rules-based are said to be “passively” managed in contrast to “actively” managed funds where discretionary decisions are taken by managers on the basis of fundamental analysis. Passively managed products can charge very low fees because they are run systematically by computers, and as scale rises and computer costs decline they can continuously cut expenses further.

In the U.S. market alone, there are currently over 250 ETFs investing in emerging markets, with total assets of $250 billion. Including mutual funds, there are approximately $500 billion invested in EM assets in the U.S. market, of which about 60% of the total is invested passively. This compares to a 60/40 mix in favor of actively managed funds just five years ago, which shows how rapidly the industry is changing.

To get an idea of the characteristics of the passively-managed universe in emerging markets, we can look at the data provided by the website ETF.com.

The chart below shows the 20 largest EM ETFs as of September 30 of this year. There are several points that we can highlight:

  • The EM ETF world is already highly concentrated. The battle for this space was won in the early stages by Blackrock and Vanguard. 87% of all EM ETF assets are held by the twenty largest ETFs, of which 60% and 30% are in the hands of Blackrock and Vanguard, respectively. Charles Schwab, though a late comer, has successfully used its distribution power to become a significant third force.. All the remaining players have niche strategies, but most lack differentiation and scale. Not surprisingly, rumors abound of M&A activity to promote further consolidation.
  • The space is very dominated by basic global emerging markets (GEM) index products: Blackrock’s IEMG (MSCI EM) and Vanguard’s VWO (FTSE EM). The fees for these products have plummeted; in fact Blackrock’s initial GEM product, EEM, now slowly dissipates because of its “exorbitant” 0.67% expense ratio, compared to IEMG’s 0.14%. The cheapest GEM fund is now State Street’s SPEM (S&P EM), with a fee of 0.11%.
  • To lower expenses and remain competitive there is a broad trend for smaller firms to develop their own indexes.
  • With relentless pressure on fees,  industry asset-gatherers need to be creative to differentiate products from the basic GEM funds. Based on the complexity and marketing attractiveness of these differentiated strategies, fund companies aspire to secure higher fees.

GEM Plus Funds

The most basic differentiation strategies are “GEM Plus” funds where the manager has introduced a tweak to the basic GEM product which is deemed to be of interest to investors. These include the following:

    • RAFI Products – These funds, based on the Research Affiliates Fundamental Index, weigh stocks on the basis of fundamental characteristics (sales, cash flow, dividends and book value) in contrast to the market capitalization weights that are the rule for the big GEM funds. This provides investors with a “value” tilt, and periodic rebalancing to harvest mean reversion. The funds using the RAFI index are currently charging between 39-60 basis points, a large premium over the standard GEM funds.
    • GEM with Exclusions – These funds charge a moderate fee premium of 5-20 basis points and many keep their costs down by creating their own indexes:
        • GEM minus China.
        • GEM minus state-owned companies
        • GEM minus stocks which violate ESG (environmental, social and governance) standards.

 “Smart-Beta” Funds

The next area of differentiation is with the so-called “smart-beta” products. These funds seek to exploit academically recognized investment factors (value, growth, small cap, quality, income, momentum) which historically have provided higher returns.  These funds can be divided into those that focus on only one factor and those that combine multiple factors into their algorithm. In recent years, a wave of multifactor products have hit the market, most of which use a combination of factors deemed to provide benefits of diversification and non-correlation. Single-factor funds currently tend to charge fees between 30-50 basis points, while  multi-factor funds tend to gravitate towards the high end of that range with some closer to 60 basis points.

Country and Regional Funds

Another area of great importance for ETFs are country and regional funds. Single-country products have always found traction with investors, and some country funds have been around for decades, first in the form of mutual funds and now largely as ETFs. Many of these products enjoy legacy fees which range between 50-70 basis points which they can sustain because of their strong market presence. This segment is firmly dominated by Blackrock’s Ishares funds. Both Van Eck and WisdomTree have had some success by entering niche products and developing their own indexes. Franklin Templeton is the latest entrant in this space with its suite of low cost country funds (19 basis points) indexed to FTSE, but so far it has had limited success.

Sector Funds

Finally, sector funds are a poorly developed segment of the market. On a global basis, only a few funds have been launched, with the Ishares EM technology ETF (EMQQ) having had the most success. Several GEM consumer funds have also been launched by Columbia, WisdomTree and Kraneshares. These funds have high expenses (50-90 basis points). EMQQ currently charges 86 basis points.

An entire suite of China sector funds has recently been launched by Mirae, so far with limited success. These funds have 65 basis points of expenses.

The following chart summarizes the data for the EM ETF Universe. The first column shows the percentage total assets in each major segment and the second column shows the fee expense ratios for each segment.

% of Total Assets in Each Segment Average Annual Fee
Gem 65.43% 0.23%
Fixed Income 11.09% 0.38%
Country/Regional 16.82% 0.64%
One Factor 4.07% 0.38%
Multi-Factor 2.59% 0.56%

 

 

Trade Wars

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India Watch

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China Watch:

  • Expected returns in China (UBS)
  • China-Russia: cooperation in Central Asia  (AsanForum)

China Technology

 

Brazil Watch

EM Investor Watch

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Tech Watch

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