Emerging markets ETFs ruined by idiots, study finds

If you cannot find South Africa on a map, and you do not know who China’s president is, you should not be buying emerging markets ETFs, according to a recent study.

Jimmy Kimmel once asked Americans on a shopping street to name any country on a map.  They were allowed to name any country – including the US. All they had to do was point to one and say its name. Amusingly, most of the shows’ guests struggled.

A similar ignorance seems to be plaguing investors in emerging markets ETFs, a new study has found.

Most investors buying emerging markets ETFs know nothing about the countries they’re investing in. Their ignorance means ETFs are having a negative impact on EM countries’ capital markets, as ignorant investors tend to jump ship at the first sign of trouble.

“The rise of ETFs as a vehicle for international capital flows has amplified the effects of the global financial cycle in emerging markets,” it said.

“Why do ETFs alter the behaviour of cross-border financial flows in this way? Our findings are consistent with the hypothesis put forward by [other academics] that ETFs attract investors who value the greater liquidity and who are relatively uninformed.”

The study, entitled How ETFs Amplify the Global Financial Cycle in Emerging Markets, was headed up by Tomas Williams, an assistant professor of international finance at George Washington University, and Nathan Converse, a senior economist at the Federal Reserve.

It looked at fund flow data for 2,500 emerging markets ETFs and 13,000 mutual funds, and how flows changed in the face of global financial conditions and changes in emerging market economies. Global financial conditions were measured by the St Louis Fed Stress Index, which looks at interest rates, spreads, volatility, and other financial variables. Emerging markets economic activity was measured by industrial production.

It found that while ETFs make up only 20% of money in EM equity funds, and are far outweighed by money in EM mutual funds, it was ETFs that were doing the damage.

“Mutual fund investors respond to changes in economic conditions in the countries where these funds invest, but ETF investors do not,” it said.

“The greater sensitivity of ETF flows deepens exposure to the global financial cycle, raising the volatility of financing conditions in recipient economies.

“This somewhat surprising finding is in fact consistent with [studies finding] that US stock prices respond less to firm-specific information about future earnings when ETFs hold a larger share of the stock.”

It added that this difference had nothing to do with passive management, as flows into passive mutual funds were not more sensitive to global conditions than flows into active mutual funds. It also had nothing to do with cost: there was no difference in flows between low and high cost mutual funds.

Emerging markets ETFs going from strength to strength

What mattered, the study concluded, was the intraday liquidity ETFs provide.

The growing power of speculative financial capital in developing economies pre-dates ETFs, the study notes. But the rise of ETFs seem to have exacerbated it.

The study adds to a growing body of literature that questions the effects of EM ETFs on their underlying economies.

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