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., 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.”
Bogle’s Criticism
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
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.
Less Liquid
“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.