Volatile Emerging-Markets ETF Flows Mask Growing Allocations to the Developing World

Historical asset flow and Morningstar Investor Returns data show that investors tend to chase performance. Emerging-markets funds would seem to be particularly susceptible to performance-chasing given their pronounced volatility. For example, in 2008, the MSCI Emerging Markets Index plummeted 53% and then rallied 79% in the following year. 

Looking at the charts below, emerging-markets fund flows appear to rise and fall along with market performance. Chart 1 is a graph of the annual returns of the MSCI USA Index, the MSCI EAFE Index (an index of stocks in developed foreign markets), and the MSCI Emerging Markets Index. Chart 2 graphs the annual net flows into and out of three categories of funds--U.S. equity funds, foreign developed equity funds, and emerging-markets equity funds--as a percentage of total net assets invested in those funds at the start of the year. The funds in Chart 2 include both exchange-traded funds and mutual funds.

Chart 1: Annual Market Performance
Source: Morningstar Direct.

Chart 2: Annual Growth in Category Fund Assets From Asset Flows

Source: Morningstar Direct.

Flows Into Emerging-Markets Funds Have Been Strong,
Despite Recent Weak Performance
While the correlation between emerging-markets performance and flows into emerging-markets funds has been 79% during the period in question, we note that since 2002, flows into emerging-markets funds actually have been positive every year, including in 2008 and 2011, when the MSCI Emerging Market Index fell 53% and 18%, respectively. Additionally, from January 2010 through June 2013, flows into emerging-markets funds have significantly outpaced flows into U.S. equity funds, despite emerging-markets equities' relative underperformance during this span.

 

Investors Are Still Underweight Emerging-Markets Equities
After a decade of strong flows into emerging-markets funds, it appears that investors have carved out a permanent home for emerging-markets stocks in their portfolios. Chart 3 is a graph of our proxy for investors' aggregate allocation to emerging-markets stocks. The chart depicts the total amount of assets invested in U.S. domiciled emerging-markets funds (mutual funds and ETFs) divided by the total assets invested in all equity funds as well as all equity and bond funds combined. Using the Morningstar Moderate Target Risk Index (a global portfolio with a 60/40 mix of stocks and bonds) as a proxy for the average investor, a target allocation to emerging-markets equities (which includes stocks from Taiwan and South Korea) would be 4.5% of the value of a 60/40 stock-bond portfolio, or 7.7% of the equity portion of that portfolio. Another suitable benchmark would be the market-cap-weighted MSCI All Country World Index, which covers approximately 85% of the world's investable equity-market capitalization. Emerging-markets stocks account for around 10% of this global stock-market barometer.

 

Chart 3: Emerging-Markets Fund Assets as a Percentage of All Fund Assets

Source: Morningstar Direct.

As can be observed in Chart 3, only recently have investors drawn near these neutral allocations to emerging-markets stocks as defined by the Morningstar Moderate Target Risk Index. And as of the end of the second quarter, investors' aggregate allocation to developing-markets equities has actually declined. Emerging-markets funds accounted for 3.9% of total fund assets and 6.0% of total equity-fund assets as of the end of June, thanks to a combination of slower inflows and relatively poor performance. 

This data suggests that the trend driving asset flows into emerging-markets stocks over the past 10 years has been a wholesale shift toward having permanent allocations to the asset class, and not merely performance chasing. Even during the years leading up to the 2008 financial crisis, when emerging-markets stocks were returning more than 30% a year, investors were still significantly underweight emerging-markets funds. Emerging-markets stock funds have come a long way in the past 10 years, evolving from a tiny satellite holding (of less than 1%) to a core holding in many investors' portfolios.

 

What About Emerging-Markets Exposure in Foreign-Equity Funds?
Emerging-markets securities also have found their way into many foreign-equity funds that focus primarily on international developed equity markets. Over the last three years, foreign large-blend funds, on average, had nearly 10% of their portfolios invested in emerging-markets stocks. Funds in Morningstar's foreign large-growth category have tended to have slightly higher allocations to emerging-markets stocks, while funds in the foreign large-value category have tended to have slightly lower allocations to emerging markets.

If we include the slices of these funds allocated to emerging-markets stocks in our analysis, then assets invested in emerging-markets funds would account for 7.6% of assets in all equity funds, which is still slightly below the Morningstar Moderate Target Risk Index's 7.7% allocation. However, assets in emerging markets as a percentage of assets in both stock and bond funds is currently 5.0%, which is slightly higher than the allocation within the benchmark. 

Investors who use Morningstar.com to gauge their exposure to emerging-markets stocks should note that our database classifies South Korea and Taiwan as developed markets. These markets account for about 3% in the MSCI All Country World Index.

Emerging-Markets Fund Flows--ETFs vs. Mutual Funds 
During the last few years, large flows in and out of emerging-markets stock ETFs have grabbed more than their fair share of industry headlines. Chart 4 compares the monthly flows in actively managed emerging markets stock funds with the monthly flows in passively managed emerging-markets stock funds. The crop of passively managed emerging-markets funds is primarily composed of the Vanguard Emerging Markets Stock Fund (all share classes), the  iShares MSCI Emerging Markets Index (EEM), DFA funds, and other ETFs. While EEM accounts for about 22% of all assets in passively managed emerging-markets equity funds, it has driven a disproportionately large amount of the volatility in the category's fund flows. In March and June of this year, flows out of EEM were $4.2 billion and $5.0 billion, respectively. In the same months, Vanguard Emerging Markets Stock Fund (all share classes), which accounts for 32% of the category's passive assets, saw smaller outflows of $0.9 billion and $1.2 billion, respectively.

 

Chart 4: Monthly Active and Passive Emerging-Markets Fund Flows

Source: Morningstar Direct.

 
The takeaway here is that monthly emerging-markets ETF flows are a noisy, short-term sentiment indicator, as ETFs--and EEM in particular--have become highly liquid access vehicles for emerging-markets equity exposure. These monthly data points can mask longer-term trends. While there were heavy net flows out of passive emerging-markets funds in March and June of this year, in the first seven months of 2013, net flows into emerging-markets funds were positive at $21.8 billion. Actively managed emerging-markets stock funds have seen positive net flows every month in 2013, as have smaller passively managed emerging-markets funds.

 

Will Flows Into Emerging Markets Continue?
Any further hawkish language from the Federal Reserve likely will drive short-term volatility in emerging-markets fund flows, which could impact asset prices as well as currencies. This, combined with the fact that investors, as a group, are near neutral allocations to the asset class (as suggested by the Morningstar Moderate Target Risk Index) may result in a slowing or reversal of flows going forward. But given the positive long-term trend, which has been masked by a recent bout of volatility, most investors are likely to remain committed to their emerging-markets equity allocations, and it is unlikely there will be a mass exodus from emerging-markets stocks in the medium term.

 

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