The WSJ featured an interesting viewpoint in “Are ETFs Causing an Emerging-Markets Bubble?” Here are a few highlights:
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.
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.
Even Gus Sauter, chief investment officer at Vanguard Group, one of the world’s largest managers of index funds and ETFs, is concerned. “Obviously it’s the last trade that determines the price of everything,” he says, “and there have been large flows [from ETFs into emerging markets], perhaps leading to a bit of a bubble.”
Mr. Sauter adds that several markets, such as Brazil and Peru, are up roughly 100% in 2009. “Either something has changed quite dramatically,” he deadpans, “or pricing has been dislocated from reality. And it’s probably a little bit of the latter.”
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. Ms. Ting says that her fund automatically sells some of its Petrobras holdings, currently 23% of assets, whenever they near the 25% threshold. They are replaced, she says, with “securities with similar risk factors.”
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.
As a general rule, I don’t think bubbles in any market pop over night. Sure, you may have the occasional Black Swan event, but even during last year’s market crash, prices started to head lower at a slow pace at first and accelerated later on.
Take a look at the EEM chart above. For those with sell stops in place, the initial market pullback provided plenty of opportunity to liquidate any positions. Even if you gave yourself more room and sold as the price crossed the trend line to the downside, you would have had no problem getting out.
As always, the key here is not to worry about wild speculations as to what might or might not happen to this market but to be prepared to exit when the trends reverse.
That alertness to changing conditions, more than anything else, will save your portfolio from a receiving a severe haircut and will help you emotionally to better deal with a declining market.
Disclosure: We currently have no positions in EEM.