A Franklin Templeton manager has warned of the dangers of exchange-traded funds which invest in emerging markets, claiming they give the impression markets are "like a casino".
ETFs offer investors a low cost way to access markets, mainly as tracker funds.
Carlos von Hardenberg, who runs Franklin Templeton’s £1.9bn Emerging Markets Investment trust, has said investors need to be careful of emerging market ETFs because they can inflate prices when they buy and deflate prices when they sell.
Mr von Hardenberg said investments into passive emerging market products have ramped up significantly over the past four years and are now receiving very large inflows.
He pointed out that ETFs only invest in listed companies in one index, and said the nature of their formula means these products only buy large caps, and therefore miss out on opportunities from small and mid cap firms.
“It’s very dangerous, and creates the impression that markets are much more like a casino because ETFs don’t focus on fundamentals, earnings, or quality of management; they just focus on size, so when it’s big they buy.”
He said ultimately this creates a market that is increasingly concentrated on index names and larger companies, and as ETFs become bigger, the price impact of their buying and selling becomes more significant.
Mr von Hardenberg also said ETFs have to buy certain investments when markets get reclassified, so for example, they are forced to purchase stocks from Argentina and Pakistan when the countries are upgraded to emerging market status.
According to Mr von Hardenberg, this upgrading and downgrading of markets creates a lot of what he described as “artificial volatility”.
“Emerging market investments are often less liquid and are affected by the purchasing of ETFs,” he said, adding this is even more of a problem when hedge funds try to position themselves in the stocks which they believe the ETFs will buy in the future.
ETFs just focus on the size of companies, so when it’s big they buy Carlos von HardenbergA report from Source predicted the popularity of exchange-traded funds would increase at a rate which could see the market double in five years.
However, in August, research from ETFGI revealed new money going into equity ETFs had plummeted by 85 per cent in a year.
The Franklin Templeton trust, which is one of the largest closed-ended emerging market vehicles in the UK, has returned more than 49 per cent over the past year, outperforming the Global Emerging Market Equities sector, which has returned 28 per cent, FE figures reveal.
Mr von Hardenberg said he is seeing opportunities in the mid and small cap arena, particularly as companies embrace technology.
“Technology has been leap-frogging in emerging markets, which is leading to competitive business models that will outgrow the more established markets.”
He said emerging markets are generally moving away from the low-cost low-value production to more high-end “complex” goods.
The trust manager also said he has been tapping into smaller markets, like Kenya, Nigeria, and Peru, where companies are still at good prices because the big index funds can’t buy them or don’t buy them yet.
Mark Fitzgerald, head of product at Vanguard’s European division, said: “Although the headline numbers on funds flowing into ETFs are impressive, they still only represent a small percentage of total investable assets.”
He also said the vast majority of ETF trading activity takes places in the secondary market, with investors exchanging ownership of shares in the funds, rather than in the underlying securities themselves.
Wei Li, head of investment strategy at iShares EMEA, said: “As more volatile markets warrant greater flexibility and tactical strategies, more and more investors are using ETFs to actively transfer risk between exposures within their portfolios.”
Peter Lowman, chief investment officer at Investment Quorum, said: "Mr von Hardenberg‘s comments do have some justification, given the nature of the beast.
"We all know that within the emerging markets there are at times when we experience the good, the bad, and the ugly, both from a geographical and company-specific perspective.
“Indeed, the ETF is a vehicle can be used in a portfolio to gain client exposure to a market, irrespective of company fundamentals and the quality of the business, which can be advantageous, but devastating when markets are toppy."
Mr Lowman said using ETFs correctly can be very rewarding, but pointed out with emerging markets, an experienced fund manager can add “tremendous value” over the long-term, especially if they avoid inflated share prices and cover large, mid and small size companies.
