Across the world, fund managers are showing apparently insatiable demand for investments in developing countries, driven by slack growth rates in the G7 economies to seek higher returns elsewhere.

In the US exchange-traded funds market, the world’s largest, iShares’ MSCI emerging markets tracker (NYSE Arca: EEM), and Vanguard’s version of the same fund (NYSE Arca: VWO), were two of the only four ETFs in the world with assets of more than US$40 billion at the end of October, according to National Stock Exchange data (the SPDR S&P 500 fund and the SPDR Gold fund are first and second in the list).

According to research from Deutsche Bank, ETF assets benchmarked against the MSCI emerging markets index in the US are now close to US$100 billion. When measuring the popularity of the benchmarks tracked by exchange-traded funds, that total lags only the near-US$120 billion that is invested in funds following the S&P 500 index.

When measured by net new assets, Vanguard’s VWO is by some margin the leading asset-gatherer amongst the world’s ETFs so far in 2010. It has attracted US$16.5 billion in invested cash over the first ten months of the year, nearly doubling its size. Meanwhile, iShares’ EEM is in third place in the table for assets gathered (after SPDR Gold), with US$4.3 billion in net cash inflows.

These huge funds represent enormous revenue generators for their operating companies. In the case of iShares’ EEM, the fund’s size of US$49 billion, when combined with a 0.72% total expense ratio, implies an annual revenue stream to BlackRock, iShares’ owner, of more than US$350 million from this one fund alone.

If securities lending revenues are added into the picture, one industry expert observed, iShares could be making closer to US$500 million a year from EEM. The firm credits half of any revenues from securities lending to the fund’s investors, but retains the remaining 50%.

And the fund continues to gain assets despite well-publicised performance problems against its index: it’s adrift by nearly 3% in 2010 to date, post fees, from the MSCI benchmark, following a near-7% underperformance in 2009.

Meanwhile, Vanguard’s VWO, which has underperformed the index by a lesser margin (by around 0.5% after fees in the year to date) continues to gain market share against its competitor. VWO’s lower fees (0.27%, compared with EEM’s 0.72%) have also helped it to grow in relative size.

On the European side of the Atlantic, it’s a similar story, with two large funds dominating the sector.

Both iShares’ European version of its broad emerging markets benchmark (LSE: IEEM) and db x-trackers’ swap-based ETF based on the same index (Xetra:XMEM) are now approaching US$6 billion in assets, having tracked each other in size almost exactly since early 2009. And the growth rate of both funds has been spectacular, even if the funds are still quite a bit smaller in absolute terms than their American counterparts.

IEEM, for example, has increased its assets under management nearly six-fold since the beginning of last year, partly due to market price increases but with investor cash flows playing a more important role.

IEEM and XMEM have also tracked each other more closely performance-wise than the two leading equivalent competitor funds in the US market: IEEM is up 15.08% over the year to November 12, while XMEM has increased by 15.46%, both compared to an index return of 15.59%. The iShares fund, which charges an annual fee of 0.75%, also has a smaller differential in price from the db x-trackers ETF (which charges 0.65%) than the difference between the US market’s EEM and VWO.

Taking IEEM as a measure of investor demand for the emerging markets sector as a whole, there has been a recent acceleration in buying. Over the three months to 12 November 2010, the fund had added over US$1.5 billion in assets, a record rate of growth for the fund as measured by a quarterly rolling total of assets under management.

Can this frantic buying of emerging markets continue, or are investors now risking capital by chasing the trend too far?

Several leading strategists have recently pointed out warning signs for those putting money into the sector, including the chief economist for the firm which has benefited most from the investor inflows, Vanguard.

As quoted recently in a Wall Street Journal article, the firm’s chief economist, Joseph Davis, argued that “it isn't a lock that emerging-markets stocks are going to outperform going forward”. When measured by a trailing price/earnings ratio, emerging market stocks now no longer trade at a discount to stocks in the US, Davis pointed out.

Michael Hartnett, strategist at Merrill Lynch, sounded a similar note of caution when reflecting on his firm’s latest (October) survey of investor expectations. Merrill Lynch’s survey is widely used as a measure of professional investors’ sentiment, and can be viewed from a contrarian viewpoint; if everyone is long a market, who’s left to buy?

Noting that a net 49% of survey respondents had moved to an overweight position in emerging markets, Hartnett said, diplomatically, that “while improved risk appetite is to be welcomed, one proviso is just how narrow the investor focus on global emerging markets is at this point."

From the perspective of many emerging market governments, a slowing down of this year’s incredible money rush would also be welcome.

Brazil’s finance minister, Guido Mantega, warned in September of an “international currency war” in response to the US Federal Reserve’s plans to adopt a second round of quantitative easing. Brazil’s government has twice put up taxes on capital inflows during the last year, in a bid to deter speculative buying of Brazilian equities and domestic bonds, which are in turn pushing up the value of the real. Meanwhile, China is clearly struggling with inflationary pressures as a result of hot money inflows, leading to a prospect of interest rate rises to slow down the economy.

Whether such government interventions can reverse the mad scramble by investors to buy developing countries’ shares, or whether the boom will subside and reverse by itself remains to be seen. But one thing is clear: it’s been a record-breaking year in emerging markets.

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