What ETF flows say about emerging market debt opportunities

Many investors view the trade war scenarios as especially negative for emerging market debt (EMD). How do we know? By the sharp downdraft in flows to the asset class.

Recent outflows from EMD

By far the largest passive exchange-traded fund (ETF) is iShares JP Morgan Emerging Markets Bond ETF, which tracks the emerging markets sovereign bond index. It has lost about $2.5 billion in assets since the beginning of April.

In isolation, that number seems to suggest that EMD is in for an extended period of struggling. But history suggests otherwise. In our experience, passive ETFs are often used by hedge funds, medium-sized investors and retail investors for tactical exposure to the asset class. So large swings in assets are hardly unique.

Historical trends

In each year since 2014 there has been a single brief but sharp period of outflows. On each occasion assets have been left around 15-19% lower. The exception was 2017 which saw a more modest fall of around 11%, as shown in the chart below.

Source: Bloomberg, 22 May 2019

What happens after this is what is most interesting. In the next three months, once the outflows bottom, investors have experienced positive returns in the emerging markets sovereign dollar bond index every year except for in 2018.

We list below the approximate index returns* for the three months after the iShares JP Morgan Emerging Markets Bond ETF’s assets bottom from the annual sharp period of selling:

2014: 0.11%

2015: 1.99%

2016: 3.26%

2017: 2.99%

2018: (-1.57%)

What does the current episode suggest?

In the past six trading days, assets have risen by a small amount which suggests the worst may be over if history repeats itself. Since there have never been two consecutive years of negative dollar returns in the past 23 years, we view this episode as more an opportunity than a cautionary tale.

*Figures depicts the three-month return of the EMB ETF following the sharpest outflow periods during the calendar years 2014 through 2018. Performance shown reflects past performance, which is no guarantee of future results. Results are not annualized. Other vehicles and funds would have achieved higher or lower results as this is for illustration only. Other longer-term periods would have achieved different results. AUM trough months for the EMB ETF for the last few calendar years were: May 2018, January 2017, February 2016, January 2015, and May 2014.