Ben Bernanke’s comments that the Fed may start to wind down quantitative easing sparked bond-market volatility were the main reason for powerful outflows from the ETF market— the place to read the tea leaves in contemporary financial markets, ConvergEx Group’s Chief Market Strategist Nicholas Colas said.
But through the record outflows in June of $12 billion that were led by fixed-income and emerging-market redemptions, ETFs retained their most alluring quality, which is that they are faithfully reflecting the confusion of investment markets with immediacy and transparency, Colas told IndexUniverse.com Managing Editor Olly Ludwig.
But through the Fed-related confusion that pulled the ETF asset-gathering juggernaut off the record-setting it had been on until June lurks an interesting possibility:As inventors gather themselves and take on risk once again, some may find the time is right to get in the frontier markets the outsized returns they once found in emerging markets, Colas said.
IndexUniverse.com:What did you make of the June outflows? There were outflows of about $9 billion from international equities and about $8 billion in fixed income, and those outflows were offset by almost $5 billion of inflows into U.S. equities.
Colas: It does feel like the flows are more volatile than in prior periods of market volatility.
IU.com:IU.com:Can you take a step back and look at those volatile flows, and identify the different variables that might explain this?
Colas: I think about it like it’s a bull’s eye in a target, or a hurricane with all its rings around it:The center of all this comes down to fixed-income asset class volatility. If you look at the implied volatility or the historical volatility of any of the large fixed-income ETFs, you’ll see that their current levels of volatility are at much higher levels than the history of the last year. So we’re living through a period of unusually high volatility for an asset class that has been known for its distinctly low volatility.
IU.com:That makes me think of the Fed Chairman’s comments back on May 22 about tapering quantitative easing, perhaps in 2013. Shortly thereafter, the market started doing all kinds of things, and the yield on the benchmark 10-year Treasury note went up around 100 basis points. How do you see it? Is it Fed driven, or is it other things?
Colas: I think it’s 80 percent the Fed and 20 percent all other. The Fed is by far the dominant factor. We’ve gone through a very long period of very high predictability of Fed action. We’re transitioning to a period of very low predictability of Fed action. We’re not necessarily saying that they’re going to be tightening or that they are tightening, but it’s a matter of by what degree are they keeping monetary policy loose. That degree is now unknown, where it wasn’t unknown a month ago.
IU.com:Before you talk more about the Fed, can you speak to the “20 percent” for a moment?
Colas: The 20 percent I categorize as all other—I think China has a role; I think the social protests in Brazil have a role. The BRICs countries, prior to the last year, have been very good investments for a long period of time. It’s where growth investors went to get that final level of accelerated economic growth.
But now that those economies are either slowing, in the case of China, or going through social problems in the case of Brazil and, to some degree, even India and Russia, I think investors are looking at that and wondering:“Where is the growth globally; where can we go?”
IU.com:By the way, some of the least popular funds last month were EEM at No. 2 and VWO at No. 3.
Colas: We can’t forget commodities either—gold. If you look at GLD and IAU, you’re looking at well over $2 billion in outflows the last month.
IU.com:Looking at gold’s pullback in terms of price and holdings in ETFs like GLD and IAU, do you see signs of normalization in the macroeconomy?
Colas: My experience looking at gold is that it’s an emotional investment to many people. And by that I mean they inherently love it or they inherently hate it. There are very few people in the middle on gold. But it means that when you have an emotional position, you’re very much more prone to acting on price movement as the catalyst.
So when it’s going up, you buy more, and when it’s going down, you sell it. And I think that’s what you’re seeing with gold ETFs. This is an emotional investment people have made over time, and it’s not working. It’s easier to hang onto a losing investment if you know precisely why you’re there. But even the strongest gold bug will get weak-kneed when they see these price moves.
IU.com:So you’re not ready to say this is telling us something very important about a normalization of the economy?
Colas: That’s right. Gold is, at best, an imperfect measure of economic activity. It really is a psychological investment, and people own it for very different reasons than they own financial assets.
IU.com:Now regarding the emerging markets and the pullback there, do you see any reason to reconsider the bullish story we’ve heard so much about in recent years?
Colas: Well, talking to clients, it feels like they still believe in the emerging markets story, but ones that are really committed to the need to find growth are going to frontier markets now.
IU.com:The deeper story here is that some are willing to take on more risk to get growth, and they’re doing it in the frontier markets. And what about the securities available? The iShares ETF comes to mind, the iShares MSCI Frontier 100 Index Fund (FM).
Colas: Well, it’s not an easy place to invest. Everything from the 30 days required to settle some securities in some markets, to a lack of transparency in financials, management access, management practices; governments and rule of law—you have acres and acres of risk.
But for investors who are looking for growth, they say, “I’m going to own this asset for 10 years and we’re going to get 7 to 10 percent growth structurally.” Not a lot of places in the emerging markets can do that—there are more in the frontier markets.
IU.com:So are you saying that the emerging markets are exhibiting a risk profile quite like they have historically, and yet the return profile is a bit more like developed markets than ever before? So therefore people may go to the frontier markets for more growth for that particular sliver of their portfolios?
IU.com:Let’s go back to the Fed for a moment. That’s the big story line—the 80 percent, as you characterized it. Is there anything surprising you’ve witnessed in the past several weeks as the Fed has started to recalibrate its message that gives you pause and makes you say, “I did not see this coming”?
Colas: Not to be cute about it, but the biggest surprise was that anybody was surprised. If you had said a month ago that equity markets are going to sell off because the Fed’s going to announce it’s going to start to tighten QE, people would have laughed because people have been talking about when the Fed is going to start removing QE for as long as there has been QE.
But that’s exactly what happens. So the biggest surprise is the volatility that has greeted that change of Fed direction.
IU.com:Are you suggesting that the surprise you’re talking about has exacerbated the volatility, or am I getting too cute myself?
Colas: It’s a good way to characterize it—I don’t know if it’s too cute—volatility is begetting more volatility. The Fed came out and made its original statement; the market freaks out; then the Fed comes out with some subsequent speakers and they try to calm the waters, and it seems to be working.
I guess it’s surprising that the market has taken it with such a shock. We were very extended with very high valuations and not really at a level where we could incorporate a lot of risk, and that’s why the market overreacted and reacted so strongly to the Fed.
And to tie it all back to ETFs, what has been interesting to me and why I’ve been watching the flows data so closely is the price volatility has had an inordinate effect on investor flows. This price volatility is engendering action.
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