Emerging market ETFs have been more volatile than their underlying indices, according to recent media reports. Should investors be concerned?
Investment researcher Morningstar says no.
“In the month of June, the market price of iShares MSCI Emerging Markets (NYSEArca: EEM) had a volatility that was 27% greater than its index and an annualized tracking error of 25%. While that might sound alarming, the exchange-traded fund has actually functioned superbly,” writes Morningstar ETF analyst Michael Rawson. “The concern lies not with the fund, but with how volatility and tracking error are being used.” [ETF Premiums, Discounts and Volatility]
Bloomberg News in a separate report from July pointed out that share prices for the 10 largest diversified emerging-market ETFs “on average were 42.6% more volatile than their underlying indexes from May 22 to June 24, when comments by Federal Reserve Chairman Ben S. Bernanke triggered a selloff that sent emerging-market stocks to a one-year low.”
The story did note that providers said the extra volatility resulted from ETFs trading while the underlying emerging markets were closed or illiquid. “While the price swings have little impact on long-term investors, excess volatility can spur bigger losses if clients trade in times of market turmoil,” according to Bloomberg.
ETFs tracking international markets can trade at premiums or discounts to net asset value (NAV). These deviations occur because the ETFs continue to trade in the U.S. after the overseas markets close for the day.
“It is not unusual that the ETF has higher volatility than the underlying index, in periods of extreme global market volatility,” said Robert Nestor, head of global product marketing at iShares, in the Bloomberg article. “The volatility in the price of the ETFs reflects investors’ reaction to market news and changes in sentiment, much of which occurs while U.S. markets are open, but emerging markets are closed.”
Morningstar’s Rawson says a few issues arise when investors try to calculate tracking error for emerging market ETFs.
“International ETF premiums and discounts will be much larger because fund NAVs are calculated based on prices when foreign markets close, many of which have stopped trading well before 4:00 p.m. in New York. Yet the ETFs continue to trade in New York, so their prices reflect information not yet embedded in their NAVs. For this reason, when an international ETF closes at a premium, we expect that premium to revert the next day when foreign markets open and the NAV incorporates the new information from the U.S. market,” the analyst wrote.
“Before dismissing ETFs that appear to have high tracking error, it helps to understand the root cause,” Rawson concluded. “High tracking error may result from technical and measurement issues.”
Full disclosure: Tom Lydon’s clients own EEM.