The rapid growth of emerging market funds, combined with “herd behaviour” by investors, threatens to be a source of “vulnerabilities” for the developing world, the Bank for International Settlements has warned.
Emerging market bond funds have seen their assets quadruple from $88bn to $340bn in the four years to the end of 2013, said BIS, quoting data from EPFR Global, while EM equity funds expanded from $702bn to $1.1tn.
Against this backdrop, Basel-based BIS, known as the central bankers’ bank, warned that over the past two years investment flows and asset prices had “amplified each other’s fluctuations”, raising the risk of emerging markets being “destabilised” by sudden outflows.
It found that emerging market fund managers used a narrower range of benchmarks than developed world managers, and investor flows were more “clustered” in emerging markets, raising the likelihood of correlated movements and “one-sided markets”.
“The way the industry is managed, [with] widespread benchmarking and short-term performance assessment, limits the degree to which individual portfolio managers can deviate from industry averages,” said Hyun Shin, a BIS economist.
“The behaviour of the ultimate investors can introduce further correlation. There is some evidence that during last year’s taper tantrum retail investors were prone to herding and they herded procyclically, which means they withdrew from funds when prices were falling and re-entered when they were rising, forcing funds to sell when prices were falling and buy when prices were rising.”
Mr Shin said institutional investors behaved in a more stable manner, “but it remains to be seen whether they will do so in more stressful periods”.
BIS warned that the prudential regulation of the asset management industry focused primarily on microprudential and consumer protection aspects. It called on policy makers to broaden their scope and “address issues that give rise to correlated behaviour across asset managers or the procyclicality of investor flows and asset prices” to design an “effective policy response”.
A senior figure at a large EM house argued that a major flaw in the system was that just 15 per cent of local currency bonds were included in mainstream indices, meaning passive funds and benchmark-constrained active funds were forced to funnel all their money into this small slice of the market. He said a solution would be for the World Bank or a similar organisation to collect its own daily pricing data, allowing the creation of far wider-ranging indices.
“There is a major market failure and the fact that it happens is an abrogation of duty on the part of international civil servants that is absolutely mind-blowing,” he said. “It would cost the World Bank or the IMF $10,000 per country per year to do this. That is a drop in the ocean.”
He also argued that EPFR data only captured a small slice of the market, mostly US mutual funds, meaning few conclusions can be drawn from it.
“The cacophony of alarmist [talk] is based on just 2 per cent of the [EM local currency government debt] asset class, it’s just a very visible 2 per cent. It’s important to put the volatility concerns into context.”