The Incredible Emerging Markets Race

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.

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