Morgan Stanley Emerging Markets Strategy
Is the ETF market a risk for EM?
Strong inflows into EM ETFs raised some concerns: Emerging Markets have enjoyed a record inflow in 2017 with an increasing number of investors using ETFs as a vehicle to invest in EM. ETF inflows now account for a round 40% of the inflows YTD and major EM bond ETFs have doubled their AUM in the past two years. This raises the concern that a reversal of ETF inflows and potential forced selling could lead to a hard landing in Emerging Markets.
ETFs’ holdings of EM assets are low: On average, EM ETFs hold around 1%, 5% and 4% of EM local currency, sovereign credit and equity market, respectively. Three factors contribute to the low ETFs’ holding of EM assets: global investors still under- invest EM in their portfolio allocations; active bond funds still offer value vs passive funds, in our view; and EM bond markets are less liquid.
Stickiness of ETF investors underrated: While it is difficult to provide an overall picture of ownership of ETFs, our fund-level analysis shows that at least 20% to 25% of the ETF investors are institutional. This is in line with our conversations with asset managers that investors, especially cross-asset strategy funds, use ETFs as part of their allocation into EM. Hence, ETFs’ flow could be more sticky than expected.
Stress test the ETF outflows: Given most of EM local bond and EM equity ETF outflows are FX unhedged, any redemption of ETF shares and subsequent selling of underlying assets should have a negative impact on EM FX. EM assets went through a proper test during the selloff after the US election. Both GBI-EM and FTSE Emerging Markets Index lost 8% with in the two months and EM local currency ETFs and EM equity ETFs saw outflows of 10% and 2% of the AUM each. Under the assumption that similar outflows could happen to current AUM, we estimate the potential selling of EM FX at the country level.
Impact seems limited: The result shows that the likely outflows from EM local currency bonds are in the range of $100mm to $250mm while EM equity could trigger much bigger outflows, noticeably in Korea, Brazil, Mexico and South Africa ($300mm to $1bn). However, it is worth while to stress the actual impact could be smaller because1) such outflows could occur over one to two months. 2) the selling is still small vs EM FX trading volume 3) Some EM equities are listed in US as ADRs, hence selling equity doesn’t necessarily have any FX impact. As shown in the next exhibit, the potential outflow doesn’t correlate with the actual performance during the US election, either.
More via risk channel: To the extent that equity markets affect both EM and G10 FX, the main channel would be via risk angle. Currencies that are either sensitive to the performance of global equities or have seen rapid equity market in flows in the past year would be vulnerable. The next exhibit shows that the SEK, CAD, AUD and NOK are sensitive in G10. The comparable analysis for EM shows TRY, COP, BRL, ZAR and KRW are most sensitive.
How to use ETF flow? As we downplay the impact from ETF outflows and their impact on the market, ETF flows could still be a good indicator of broad flows. Regression analysis shows that ETF flows have a strong correlation with non-ETF flows in EM local currency, hard currency and equity funds (see the next exhibit). The beta is less than 1 in equity, indicating equity ETF outflow is more dominant. Meanwhile, non-ETF flows are 40%, or 70% more than ETF flows in local currency and hard currency bond funds.