Investments in passive index ETFs could contribute to emerging market volatility
While the emergence of exchange-traded funds has helped investors diversify into once-hard-to-reach developing economies, the increased ease of access to these overseas markets may have contributed to compounding shocks in emerging countries. .
Investment funds were much more likely than other private sector financing, such as banks, insurance companies and pension funds, to take money out of countries, according to Bank of Italy economists. developing during global recessions, reported the Financial Times.
Economists have also found that passive index funds are more responsive to global shocks than actively managed strategies. Specifically, investment flows to emerging market ETFs are even more sensitive to global financial conditions than equivalent mutual funds. Thus, silver ETFs are considered the least reliable of all forms of financing for companies in developing markets.
“Reliance on investment funds, especially those focused on benchmarks, makes emerging markets more vulnerable to global shocks,” Italy’s central bank Alessandro Moro and Alessandro Schiavone said in their article entitled “The Role of Non-bank Financial Institutions in the Intermediation of 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,” the economists added.
While greater diversification of funding sources could help reduce costs and liquidity risks for emerging countries, “on the other hand, the growing role of investment funds has been associated with capital flows more volatile,” according to the study.
“Redemption pressures are particularly severe for passive funds” during times of global market stress, according to their research.
In addition, “the growing popularity of benchmark-based investment funds, including ETFs, may increase similarity in asset manager behaviors, increasing the potential for one-sided markets and large price swings in emerging markets”.
Specifically, after examining data from the IMF, the Bank for International Settlements, and portfolio flow data provider EPFR, the researchers found that a one standard deviation rise in the so-called volatility index VIX was followed by a 1.8% drop in holdings of active funds in Emerging Bonds, compared to a 2.3% drop for passive funds. Meanwhile, the equivalent figures for stocks were 1.2% and 1.5%, respectively. With regard to ETFs, these figures rose to 2.8% for bonds and 1.6% for equities.
“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.
The flows can be attributed to the reactionary backlash and herd mentality within the ETF investing community, particularly among retail investors.
“It’s money that can return in no time,” Charles Robertson, chief economist at Renaissance Capital, an emerging-markets-focused investment bank specializing in passive investing, told the Financial Times. .
“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.
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