Strong inflows reverse emerging-markets exodus

Emerging markets exchange-traded funds have enjoyed a turnaround of sorts, with big inflows in the last few weeks on the heels of a rough first quarter. Those inflows are being driven by bright spots in developing economies, which are attracting investors taking profits from their developed-markets positions. Emerging-markets ETFs suffered more than $41 billion in outflows in the first quarter after the Federal Reserve began to wind down its quantitative-easing program. But since the end of March, more than $4 billion has gone into two ETFs that track emerging-markets equities indexes, according to data from EPFR Global. The biggest gainers were iShares MSCI Emerging Markets (EEM), at around $4 billion in inflows, and Vanguard FTSE Emerging Markets (VWO), at about $324 million, according to data from ETF.com. “This seems to be a turning point for emerging-markets flows,” said Dave Nadig, chief investment officer at ETF.com. While the uninterrupted stream of outflows from emerging markets funds may be finished, “no one is expecting these funds to shoot to the moon.” A number of developments in key emerging-markets economies are contributing to renewed investor optimism, said Paul Christopher, chief international strategist for Wells Fargo Advisors. For example, China recently announced a stimulus package that could help maintain the country's 7.5% annual growth target. In addition, there is some enthusiasm among investors about elections in India and Indonesia, which both are poised to put reform-minded candidates into office, he said. Another potential driver could be that investors are trying to lock in profits gained during developing economies' strong bull market in 2013, said Patricia Oey, a senior fund analyst with Morningstar Inc. “Generally speaking, during the period of double-digit gains in 2013, if you cared about asset allocations you could be overweight in developed markets and underweight in emerging markets,” she said. “Now that developed markets' gains have slowed, investors might be increasing allocations to emerging markets.” Mr. Nadig expects to see some near-term volatility in emerging-markets fund flows as investors “struggle to understand the relationship between emerging markets and developed markets.” Over the long term, emerging markets should experience faster growth than developed markets due to favorable demographics and rapid industrialization, Ms. Oey said. However, investors shouldn't be too quick to give up on developed markets in favor of emerging economies. “We think that developed markets have further upside and emerging markets have more room to underperform this year into next,” Mr. Christopher said. With the exception of China, most emerging economies are hesitant to undertake needed reforms, Mr. Christopher added. This includes India and Indonesia, whose reformist candidates — if they are elected — may have a hard time driving change. In addition, there is a good probability that a strengthening U.S. dollar, driven by rising rates and strong U.S. growth, could cut into near-term gains from emerging markets, Mr. Nadig said. He recommends that investors who want to up allocation to emerging markets consider currency-hedged ETFs, such as the db X-trackers MSCI Emerging Markets Hedged Equity Fund (DBEM). “Currencies in emerging markets are very volatile. The slightest political hiccup can send currencies plunging,” he said. “This is something not enough investors are cognizant of.”