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Tuesday, November 10, 2009

Not A Good Explanation for The Emerging Market Rally And I Am Not At All Sure It's A "Bubble"

Jason Zweig in the WSJ presents the argument that money flowing mindlessly into the emerging markets etfs is responsible for a bubble in those markets. As I will show not only is that argument not persuasive, the entire argument that these markets are in a bubble should be regarded with skepticism.

My bolds and italics

Are ETFs Causing an Emerging-Markets Bubble?

U.S. investors have pumped roughly $26 billion into emerging-markets funds so far this year. Of that, $15 billion came in through exchange-traded funds -- portfolios that hold every stock in a market benchmark with utterly no regard to price.

Several hedge-fund managers and other active stockpickers have told me that this "mindless money" is distorting valuations and pumping up a potentially monstrous bubble.

First off note that 42% of the money flowing from US investors into emerging markets went into active funds, add in cross border flows into emerging markets from the rest of the world and local investors in those markets and I would be shocked if US etf inflows represented more than 50% of new inflows into developing markets. Global cross border inflows into emerging market funds were $80 billion, add in hedge funds, pension funds, cross border flows within the emerging markets and local investments into home markets and that etf inflow starts to look very small.

Courtesy of Investment News here (next paragraph) is a list of institutions that have added to their emerging markets holdings as of late I would assume only a small percentage went into the emerging markets etfs, and I think it is safe to say that the new investment by these institutions (and there are many many others) dwarfs the $15 billion into etfs. Even if the market runup is due to "mindless buying" it seems more likely it is not buying of the emerging market etf.

Some funds that have added exposure to emerging markets in the past year include the 2.5 trillion Norwegian-kroner ($448 billion) Government Pension Fund-Global; the 64.25 billion Australian-dollar ($59.3 billion) Future Fund; the Ilmarinen Mutual Pension Insurance Co. of Finland, a 21.6-billion-euro ($32.2 billion) multiemployer pension fund; the $23 billion Arizona State Retirement System; the 7-billion-pound ($11.6 billion) West Midlands Pension Fund; and the Vermont Pension Investment Committee, which oversees the state's funds, including the $1.5 billion State Teachers Retirement System and the $1.3 billion State Employees' Retirement System.
The $201.1 billion California Public Employees' Retirement System is in the middle of a broader review of its global-equity portfolio, which accounted for 51.7% of total assets as of July 31.

more from zweig:

"At first blush, it is hard to imagine that they are wrong. As money pours into the ETFs, they must mechanically match their holdings to those in the emerging-market indexes. That forced buying drives up stock prices, attracting still more new money into the ETFs, spiraling stock prices even higher."

Actually market performance in emerging markets calls the above in question. If it were really market cap weighted index buying that was "mindlessly" driving up the value of stocks in the index, then those stocks with large weignts in the index would have grown in value far more than those stocks with very low weights in the index.

But that is not at all the case. and we have a point of comparison. Dimemensional Funds (DFA) has an indexed fund which holds small cap emerging market stocks (DEMSX), precisely those that have a low weight in a market cap weighted etf like EEM. That fund is up 90.1% ytd vs 65.13% for eem. If there is "mindless buying of emerging market stocks" maybe its the small caps.
(bar chart)

In fact Zweig is more skeptical of the bubble argument although the does warn of the narrowness of some of the indices.:
But that is nothing new. Some emerging-market ETFs invest in indexes that are so concentrated that they mightn't fully reflect the real economy. The Brazilian market "has been top-heavy for years," says Dina Ting, who manages the iShares MSCI Brazil ETF. "There's two big companies, and then the stocks just fall off a cliff in terms of size." Indeed, at the end of 2007, according to data from MSCI, Petrobras and Vale together constituted 50.3% of the index -- a much greater share than today. And the two companies traded at much higher multiples of their earnings and assets in 2007 than they do now.
(which should either argue that the concentration risk has diminished or that it didnt particularly impact returns in the past,

Furthermore, even if emerging-market ETFs have contributed marginally to the boom with their forced buying, some may soon become forced sellers.
Thanks to obscure provisions of the U.S. Internal Revenue Code and the Investment Company Act of 1940, which governs how mutual funds are organized, ETFs can't allow their assets to become over-concentrated in a handful of holdings. In general, they can't keep more than 25% of their money in a single stock, and at least half of their assets must be in securities that each account for no more than 5% of total holdings.
Now that emerging markets have risen so far so fast, these tax requirements may compel some large ETFs to begin selling their biggest holdings.

So what does all this mean for investors? ETFs probably haven't caused a bubble, and they might even help a bit to prevent one from forming. But many will remain superconcentrated bets on very risky markets. If you invest in an ETF with most of its assets in a few stocks and think you have made a diversified bet, the real bubble is the one between your own ears.

But if emerging markets etfs contribute marginally to the boom, why would one expect their forced selling to have more than marginal impact when they sell

In fact the argument against a bubble in emerging markets can be made on several counts:

valuation: as investment news notes:

Vinicius Silva, an analyst at Morgan Stanley, calculates that emerging markets are trading at 12.9 times their expected earnings over the next year. Since 1993, that average has been 12.8 times earninngs. Emerging markets as a whole are neither a bubble or a bargain.

In fact if one assumes emerging market gdp and thus earnings is accelerating it would seem to me a premium over the average p/e since 1993 is justified.

emerging markets as a % of world market cap. As the bar chart shows this % has been growing steadily (24% in this measure). Relative to market cap US investors are significantly underweighted in emerging markets and the slower they are to put new money in the further underweighted they will become. Using a % of world GDP as a measure the underweighting is even more significant, And I would suspect individual investors as a whole are in the same position. Top left chart (click to enlarge the bar of emerging as % of world market cap)

Investment News reports :

some consultants and money managers think that pension funds still have a long way to go and need to in-crease those allocations closer to 35% of total assets — or roughly the weighting of emerging markets in the global economy — from the current allocation of about 5% or less for the average fund.
“Where pension funds are [invested in emerging markets], relative to where they should be, is a massive underweight position,” said Jerome Booth, head of research and a member of the investment committee at Ashmore Investment Management Ltd. “This reality has been true for a while, but the credit crunch has made it much more obvious.”

So it is not surprising to see the chart (posted separately) of net flows into emerging markets. A bubble or a long overdue global allocation based on changes in the world economy.

Finally a look at this long term chart of eem may indicate that rather than a bubble on the upside this year, the markets experienced panic selling in a downside bubble last year and now are returning to a long term trendline of growth. (see nov 11 entry)

In sum I would hesitate to label the emerging markets rally this year a bubble despite the eye popping returns. Valuation, economic growth and money flows seem to justify a strong market. But emerging markets are always volatile and not for the fainthearted.

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