Emerging market ETFs: solving the liquidity problem or storing it up?

Anyone looking for financial bubbles at risk of bursting will be watching the rise of hard currency emerging market corporate bonds. Ten years ago, the asset class hardly existed. Today, at an estimated $2tn, it is bigger than the $1.6tn market in US high yield corporate bonds, familiar to investors for decades.

Investors have been drawn by high yields, offered even by investment-grade EM corporate issuers. But with high returns come high risks, and not only those related to repayment. EM corporate bonds are often dangerously illiquid, making them hard to get rid of in a crisis and meaning their prices can change rapidly when the mood of the market turns.

Last week, Robert Grossman and colleagues at Fitch Ratings published a report comparing 100 of the largest US high yielding corporate bonds with 100 of the largest non-investment grade EM hard currency corporate bonds. They found that, between June 30, 2014 and March 31 this year, 55 per cent of the US HY bonds traded on more than 95 per cent of trading days, while this was true of just 18 per cent of the EM bonds. Conversely, while 41 per cent of the EM bonds traded on less than half the trading days, this was true of just 1 per cent of the US HY bonds.

To sidestep such problems, many investors have chosen to invest in EM assets through exchange traded funds, or ETFs. These typically aim to mimic the performance of a benchmark index by buying a portfolio of assets similar to the index composition. Their managers buy more assets as investors buy into the ETF and sell them as investors sell. But when the number of sellers and buyers is roughly equal - as may frequently be the case under normal market conditions - they can be bought and sold without managers having to touch the underlying assets. Hey presto: liquidity problem resolved.

There are other advantages to ETFs. Unlike investment trusts, which they resemble in some ways, they are not listed companies, and so escape the associated costs. And their fees are much lower than those for actively managed funds.

But there are problems, too. Constructing an ETF to track a big, liquid index such as the S&P 500 is no problem. Building one to follow an index of EM corporate bonds, for example, can be much harder. There may also not be much point. "When you're in a passive fund you are forced to buy instruments you don't like in companies you don't like," says a senior manager at one big, active EM investment house.

The same difficulty becomes acute when markets deviate from "normal" conditions and prices start moving sharply up or down. Then, ETF managers will have to buy or sell underlying assets in a hurry, and an ETF's supposed ability to shelter its investors from volatility in its underlying assets may quickly disappear.

"ETFs are good for liquidity because they allow more people to access the asset class, but the flipside is that when there's a credit event, the liquidity isn't there when you need it the most," says Brian Leung, investment strategist at Bank of America Merrill Lynch.

The "taper tantrum" of 2013 gave ETFs a taste of the illiquidity that could threaten them again. Citigroup temporarily suspended redemption orders on ETFs and State Street, a sponsor of dozens of ETFs, stopped offering cash redemptions on some of its municipal bond ETFs.

For EM investors, it may be that ETFs are still too small to matter. Those specialising in EM bonds have assets under management of just $20bn - a tiny fraction of the asset class. But in equities, flows in and out of EM ETFs often match those for mutual funds, the traditional vehicle for retail investors (see charts). Mr Grossman at Fitch notes that ETFs are increasingly the instrument of choice for retail investors in US high yield. "Their weight in trading is much greater than their weight in terms of assets," he says.

Many investors, it seems, are being won over by the upside of ETFs. That's fine, as long as they are fully aware of the potential downside.

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