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By Paul Amery

Vanguard, the investment management company, faces a dilemma after this year’s rush by investors into emerging market equities.

Thursday’s admonitory comments from Jeff Molitor, Vanguard’s Chief Investment Officer in Europe, that “the rapid rate of growth and concentration in emerging markets warrant a note of caution” were crystal clear, but understated.

“Investors may also be overweighting emerging markets based on the widely held view that emerging economies will grow faster than developed markets, and thus their financial markets will outperform developed markets,” he added.

Molitor concluded: “The problem with this simplistic cause-and-effect relationship is that it ignores history and the price paid for future growth. Our analysis shows that the average cross-country correlation between long-run GDP growth and long-run stock returns has been effectively zero.

In fact, this is only the latest in a series of warnings from the firm – Vanguard’s chief economist, Joe Davis, has been banging the drum all year with the same message (see press reports from February, May and October).

But why is the firm doing this? After all, it has been a major beneficiary of the amazing 2010 emerging markets Gold Rush - which we covered from a European ETF perspective a month ago in The Incredible Emerging Markets Race.

In the US, Vanguard is owned by its clients. Its US-listed MSCI Emerging Markets ETF (NYSE Arca: VWO) commandeered an amazing US$18 billion in new assets by the end of November 2010, according to National Stock Exchange data, three times more than the nearest competitor fund in a table of net new assets received by US ETFs.

At over US$40 billion in size, VWO generates over US$100 million in annual fees for its manager, so warning investors off the emerging markets sector seems foolhardy at first glance.

However, the firm may well be looking beyond short-term monetary considerations and considering the reputational impact of any potential disruptions if this year’s torrent of money into developing markets went into reverse.

Emerging markets often lull investors into a false sense of security on the way up, only to prove highly illiquid when a trend reversal takes place.

And, more generally, investors may be underestimating the potential riskiness of the sector because they are in it via an exchange-traded, indexed fund.

As Bethany McLean and Joe Nocera, authors of ‘All the Devils Are Here’ - the best book I’ve read on the financial crisis - write: “Wall Street likes to say that indices are good because they offer transparency - everyone can see what the prices are - and liquidity, meaning that it’s easier to get in and out of trades that are based on a public index. That’s probably true. But it’s also true that indices reduce complexity to the simplicity of a published number, allow investors to think they understand a market when they really don’t and create a frenzy of trading activity that mainly benefits Wall Street.”

So, while Vanguard may be putting its short-term income stream in jeopardy by trying to distance itself from the crowd of investors who are buying its emerging market equity trackers, in the long term it’s probably both making a smart commercial move, and behaving correctly in warning of a potential overvaluation.

Whether or not such warnings have any effect is another matter - they probably don’t, judging by other recent investment bubbles. The weight of money propels prices upwards until the reversal occurs almost by itself, and with little apparent reason.

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Source: Why Is Vanguard Banging the Drum About Emerging Markets?