Passive Index ETF Investments Could Be Adding to EM Volatility | ETF Trends

While the emergence of exchange traded funds has helped investors diversify into the once hard-to-reach developing economies, the increased ease in accessing these foreign markets may have contributed to heightened shocks in the emerging countries.

According to economists at the Bank of Italy, investment funds were far more likely than other private sector funding, like banks, insurance companies, and pension funds, to pull money from developing countries during global downturns, the Financial Times reported.

The economists also discovered that passive index-based funds are more reactive to global shocks than actively managed strategies. Specifically, investment flows to emerging market ETFs exhibit even more sensitivity to global financial conditions than equivalent mutual funds. So, ETF money is considered the least reliable of all forms of funding for developing market companies.

“The reliance on investment funds, in particular those benchmark-driven, makes emerging markets more vulnerable to global shocks,” Italian central bank’s Alessandro Moro and Alessandro Schiavone said in their paper, “The Role of Non-bank Financial Institutions in the Intermediation of Capital Flows to Emerging Markets.”

“The empirical evidence points to the systemic risks connected with the procyclicality, herding behavior, and highly correlated asset movements stemming from non-bank financial institutions,” the economists added.

While the greater diversification of funding sources could help diminish the costs and liquidity risks for emerging countries, “on the other hand, the rising role of investment funds has been associated with more volatile capital flows,” according to the study.

“Redemption pressures are particularly severe for passive funds” during periods of global market stress, according to their research.

Furthermore, “the increased popularity of benchmark-driven investment funds, including ETFs, may increase similarity in the behaviors of asset managers, raising the potential for one-sided markets and large price fluctuations in EMs.”

Specifically, after reviewing data from the IMF, Bank for International Settlements and portfolio flows data provider EPFR, the researchers discovered that a one standard deviation rise in the so-called VIX volatility index was followed by a 1.8% drop in active funds’ holdings of EM bonds, compared to a 2.3% decline for passive funds. Meanwhile, the equivalent figures for equities were 1.2% and 1.5%, respectively. Looking at ETFs, these figures increased to 2.8% for bonds and 1.6% for equities.

“We conjecture that this result may be due to the fact that passive funds and ETFs investing in EM assets are more subject to redemption pressures during periods of market turbulence,” the authors stated.

The flows may be attributed to reactionary response and herd mentality among the ETF investment community, especially among retail investors.

“This is money that can flip on a dime,” Charles Robertson, chief economist at Renaissance Capital, an emerging market-focused investment bank of retail investor-heavy passive investment, told the Financial Times.

“Retail investors get a bee in their bonnet about crypto or gold or U.S. growth stocks and potentially emerging markets at times. When the confidence is there they pour in, but it’s an hour’s work to sell the ETF and get out again. This isn’t a reliable long-term source of investment that countries need,” Robertson added.

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