(Bloomberg) -- It's official: ETFs now stand atop the developing world.
Last month, assets of BlackRock's flagship ETF for emerging-market debt surged to $6.5 billion, eclipsing the largest mutual fund in the category. For the first time, ETFs are the most-popular options for both bonds and stocks from developing nations.
While low-cost index funds have long been the choice for ordinary investors in advanced economies, their rise in emerging markets is more surprising. In theory, it's easier for savvy money managers to find hidden gems and deliver outsize returns in less-developed markets. In reality, active managers worldwide are struggling to beat their benchmarks. This week, Peter Kraus, chief executive officer of fund giant AllianceBernstein Holding LP, said the industry has grown too large and may need to shrink by $10 trillion.
"Investors are voting with their wallets," said Stephen Tu, a senior analyst at Moody's Investors Service. "People naturally assume that active should be a better option than passive in less liquid and inefficient markets, but that is a misperception."
Investors are making the shift as emerging-market assets show signs of life. After three years in the doldrums, dollar-denominated bonds have gained about 8% this year as oil prices climb, China's growth stabilizes and the greenback loses some of its momentum.
The renewed demand has been a boon for BlackRock's iShares JPMorgan USD Emerging Markets Bond ETF, which invests in dollar debt issued by developing nations. In March alone, when developing-nation government bonds had their best month in four years, investors added $1.3 billion to the fund. That is the biggest inflow since the ETF started in December 2007. As of June 6, its assets had swelled to $6.8 billion up from $4.6 billion at the end of 2015.
The BlackRock ETF overtook the Pictet Global Emerging Debt Fund and the Stone Harbor Emerging Markets Local Currency Debt Fund, which both held the top spot at various times this year.
Investors are increasingly turning to low-cost ETFs -- which are typically designed to track a market rather than outperform it -- as more and more active managers fail to live up to their promises. Over the past five years, 94% of funds that actively invest in emerging-market debt have lagged behind their benchmark, according to S&P Dow Jones Indices.
LOWER FEES
Cost has played a role. At 1.2%, the median expense ratio of emerging-market bond funds tracked by Bloomberg was three times the 0.4% rate for the BlackRock ETF.
"In an environment when yield is generally low and when fees can eat into a lot of investors' return, a lot of investors are favoring lower-cost products," said Matthew Tucker, head of iShares Americas fixed income strategy at BlackRock. Higher transaction costs in emerging markets also make it less profitable for managers to pick attractive but illiquid securities, he said.
There are, of course, always exceptions. The $4.1 billion GMO Emerging Country Debt Fund, managed by Thomas Cooper, returned 8% annually over the past five years, the best among those tracked by Bloomberg. The annual return is more than 2 percentage points higher than its benchmark.
"There are some active managers that have proven themselves and should continue to do a good job," said Karin Anderson, an analyst at Morningstar.
Nevertheless, ETFs have steadily overtaken traditional funds in almost every major market. BlackRock's MSCI Emerging Markets ETF joins the $35 billion Vanguard FTSE Emerging Markets ETF as the behemoths of their category.
In the developed world, the $133 billion Vanguard Total Bond Market Index Fund dethroned the Pimco Total Return Fund as the largest bond fund on the planet last year. Meanwhile, the $373 billion Vanguard Total Stock Market Index Fund, which tracks the performance of U.S. equities, is more than twice the size of the American Growth Fund of America, the top actively managed fund.
The shift toward ETFs "is something that will persist over time," said Edward Lopez, a marketing director at VanEck Associates.
