ETF Simplicity Betrayed by Volatility in Market Selloff
Emerging-market stocks can be volatile to begin with. Investing in them through exchange-traded funds can add another layer of price swings for investors, especially in times of market stress.
Share prices for the 10 largest diversified emerging-market ETFs on average were 42.6 percent more volatile than their underlying indexes from May 22 to June 24, when comments by Federal Reserve Chairman Ben S. Bernanke triggered a selloff that sent emerging-market stocks to a one-year low, according to data compiled by Bloomberg. The group included ETFs from BlackRock Inc. (BLK), State Street Corp. and Vanguard Group Inc., the largest managers of the products. The five biggest emerging-market index mutual funds, by contrast, were 4.8 percent more volatile than their indexes.
ETFs have become a popular way for investors to access difficult-to-reach markets because they’re cheap and can be bought and sold throughout the day like stocks. Providers say the excess volatility reflects the fact that the funds provide prices and liquidity at a time when the underlying markets are closed or illiquid, which is ultimately beneficial for investors. While the price swings have little impact on long-term investors, excess volatility can spur bigger losses if clients trade in times of market turmoil.
“This proves the argument that you are not just buying a benchmark when you buy an ETF,” said Todd Rosenbluth, director of ETF research at S&P Capital IQ in New York, a unit of McGraw Hill Financial Inc. “You need to understand not only what the stocks inside the ETF are doing but the related costs, including volatility and the difference between price and net asset values.”
Jack Bogle, the founder of Vanguard Group who popularized index-based investing, is one of the most prominent critics of ETFs, which hold $1.5 trillion in assets in the U.S. He says they encourage investors to trade frequently, undermining the long-term investment philosophy that should accompany indexing.
“The exchange-traded fund is a traitor to the cause of classic indexing,” Bogle wrote in “The Little Book of Common Sense Investing,” published in 2007.
Unlike ETFs, index mutual funds can’t be traded like stocks and price only once a day. Index fund prices won’t be substantially more volatile than their indexes because there is less room for deviation. The only difference between an index fund’s price and the per-share value of its underlying index will come from the manager’s inability to exactly replicate the index in the fund’s holdings.
Higher volatility means the price of an asset can swing dramatically in a short period, increasing the potential for unexpected losses. Bloomberg calculated the volatility, or the degree of daily price variation, for the 10 biggest emerging-market ETFs using their closing prices and calculated the same figure for their benchmarks to measure how much more volatile the ETFs were compared to the index. The same procedure was repeated for the five biggest index mutual funds that invest in developing-market stocks.
The analysis didn’t measure the difference between the ETFs’ share prices and the underlying value of holdings, which is known as a discount or a premium to net asset value.
“It’s really about the liquidity of the underlying assets and it just so happens with emerging markets that you do have markets that are relatively less liquid compared to U.S. markets or stocks that trade on the London exchange,” said Dennis Hudachek, a senior ETF specialist at IndexUniverse in San Francisco.
Volatility is less of an issue for ETFs that track large and liquid markets and whose shares trade during the same hours as the underlying assets. The $143 billion SPDR S&P 500 ETF Trust (SPY), which tracks the Standard & Poor’s 500 Index, was 0.18 percent less volatile than its benchmark from May 22 through June 24.
In addition to emerging-market ETFs, certain fixed-income ETFs, such as those that invest in municipal bonds, may also see increased price swings relative to their benchmarks during periods of market stress because it’s too difficult to buy thousands of different bonds and the funds may not track the indexes exactly, Hudachek said.
Both markets experienced declines after Bernanke told Congress on May 22 that the U.S. central bank may start reducing its bond purchases.
The comments spurred a 16 percent decline in the MSCI Emerging Markets Index through June 24, the day the index hit its lowest point since June 4, 2012. Emerging-market equity ETFs had $10.3 billion in redemptions in June, according to EPFR Global, the most since the firm started tracking the data in 2001.
Even without a massive market selloff, ETFs that track emerging stocks tend to suffer bigger price swings than their underlying indexes. In the 12 months ended June 24, the ETFs in the ranking were on average 31.6 percent more volatile than the benchmark. When prices start to fall at a rapid pace, that excess volatility tends to increase.
When the MSCI Emerging Markets Index fell 55 percent in the five months starting May 19, 2008, excess volatility for the $49.4 billion Vanguard FTSE Emerging Markets ETF (VWO), the biggest dedicated to developing markets, jumped to 53.9 percent, from 34.9 percent earlier in the year. For the $33.9 billion iShares MSCI Emerging Markets ETF, the number rose to 68.2 percent in those five months in 2008, compared with 41.8 percent before the decline began.
“The extra daily volatility is a result of the premium or discount on particular products,” said Rodney Comegys, principal in the equity investment group at Valley Forge, Pennsylvania-based Vanguard. “It is important to recognize that these premiums/discounts have limited impact over longer periods since they typically revert to around zero.”
The Vanguard ETF was 60.8 percent more volatile than the benchmark it tracks in the period this year analyzed in the ranking, May 22 through June 24. Its mutual fund counterpart, Vanguard Emerging Markets Stock Index Fund, was 2.3 percent more volatile than its benchmark. The ETF reached a discount of 1.6 percent to its net asset value on June 20, its largest deviation since September 2011.
The $789 million SPDR S&P Emerging Markets SmallCap ETF (EWX) had 68.9 percent more volatility than its benchmark from May 22 to June 24, the highest among the 10 ETFs included in the ranking. The fund, sold by Boston-based State Street, focuses on companies with a market capitalization of less than $2 billion in a float-adjusted market-capitalization weighted index. Its discount hit 4.5 percent on June 20.
“During the month of June, which experienced an increase in U.S.-driven market events, EWX’s price was more volatile than its index because the ETF was incorporating more recent market information than was reflected in the index values,” said David Mazza, head of ETF investment strategy for the Americas within the SPDR ETF sales strategy group at State Street Global Advisors.
The $4.9 billion WisdomTree Emerging Markets Equity Income Fund (DEM) was 68.4 percent more volatile than its index from May 22 to June 24, the second-highest in the ranking. The top holdings of the fund, which focuses on dividend-paying stocks, are Gazprom OAO followed by Rosneft Oil Co. The fund reached a discount of 2.9 percent on June 20. Stuart Bell, a spokesman for New York-based WisdomTree Investments Inc., declined to comment on the volatility.
The iShares MSCI Emerging Markets ETF, which had withdrawals of $3.9 billion in June, was 52.6 percent more volatile than its index last month, according to data compiled by Bloomberg.
BlackRock said June 29 it was planning a program to boost “investor education” to help clients better understand how ETFs work.
“It is not unusual that the ETF has higher volatility than the underlying index, in periods of extreme global market volatility,” said Robert Nestor, head of global product marketing at iShares, which is the world’s largest ETF provider. “The volatility in the price of the ETFs reflects investors’ reaction to market news and changes in sentiment, much of which occurs while U.S. markets are open, but emerging markets are closed.”
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