Mutual funds deny systemic risk in developing markets

Mutual fund investors own only a small slice of emerging market assets and are unlikely to pose a systemic risk to the developing world, a leading trade body has argued.

A number of regulators have warned that the rapid growth of emerging market funds could be a source of "vulnerabilities" for developing markets, particularly if investors reacted to a scare by rushing for the exits en masse.

The Bank for International Settlements has claimed that retail investors were prone to "herding" during the 2013 "taper tantrum". The clustering of fund flows raised the risk of correlated movements and "one-sided markets", it said last year.

However, analysis by the US-based Investment Company Institute, due to be released today, will claim the danger posed by fund investors has been exaggerated.

According to the ICI, regulated funds (ie excluding hedge funds), hold just 8.5 per cent of emerging market stock market capitalisation and 4.3 per cent of outstanding emerging market debt, up from 6.7 per cent and 1.4 per cent respectively in 2009.

And while this accounts for 54 per cent of the equities held by foreign investors, and 28 per cent of the bonds, the ICI claims regulated funds were responsible for just 15 per cent of the $1.4tn of new foreign portfolio capital that entered emerging markets over the past five years.

Moreover, the trade body claimed its analysis showed money in regulated funds is stickier than purchases by other foreign investors, typically banks, insurance companies, sovereign wealth funds and wealthy individuals.

According to Brian Reid, chief economist of the ICI, sovereign wealth funds, not retail investors, were the biggest driver of the post-Lehman run on US money market funds in 2008.

Perhaps surprisingly, the analysis found no evidence that the flow of money into emerging market funds affected the monthly returns of EM securities, although fund investors did buy more when prices were rising.

Mr Reid argued that regulators' concerns have largely focused on the behaviour of mutual funds simply because there are a wealth of data available on the sector.

He argued that regulators should focus on gathering equivalent data on the activities of non-fund investors, as well as on improving liquidity in EM bond markets.

"Because we have a void of information there is a lot of conjecture and fear," said Mr Reid, who also suggested regulators should be willing to live with a reasonable degree of volatility.

"We have got ourselves into an intellectual corner where we seem to be terrified of any volatility in the markets at all," he said.

"The concern has been elevated almost to a level of hysteria as to what is going to happen when the US raises interest rates.

"We have to accept that there will be some volatility."

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