By JASON ZWEIG - WSJ Nov. 7, 2009

Several hedge-fund managers and other active stockpickers have told me that this "mindless money" is distorting valuations and pumping up a potentially monstrous bubble.

At first blush, it is hard to imagine that they are wrong. As money pours into the ETFs, they must mechanically match their holdings to those in the emerging-market indexes. That forced buying drives up stock prices, attracting still more new money into the ETFs, spiraling stock prices even higher.

Even Gus Sauter, chief investment officer at Vanguard Group, one of the world's largest managers of index funds and ETFs, is concerned. "Obviously it's the last trade that determines the price of everything," he says, "and there have been large flows [from ETFs into emerging markets], perhaps leading to a bit of a bubble."

Mr. Sauter adds that several markets, such as Brazil and Peru, are up roughly 100% in 2009. "Either something has changed quite dramatically," he deadpans, "or pricing has been dislocated from reality. And it's probably a little bit of the latter."

Before you panic and bail out of your emerging-market fund, however, you should know that there is a little more to this story than a bubble that so far has refused to pop. ETFs mightn't be the culprit here. And, surprisingly, they may soon be letting some of the air out of the bubble in a controlled release.

Consider Brazil. The iShares MSCI Brazil Index ETF has nearly tripled in size over the past 12 months. Now at $10.9 billion in assets, it has vacuumed up $2 billion in new money this year. Fully 38% of the fund is invested in only two firms: oil giant Petrobras and mining company Vale do Rio Doce.

But that is nothing new. Some emerging-market ETFs invest in indexes that are so concentrated that they mightn't fully reflect the real economy. The Brazilian market "has been top-heavy for years," says Dina Ting, who manages the iShares MSCI Brazil ETF. "There's two big companies, and then the stocks just fall off a cliff in terms of size." Indeed, at the end of 2007, according to data from MSCI, Petrobras and Vale together constituted 50.3% of the index -- a much greater share than today. And the two companies traded at much higher multiples of their earnings and assets in 2007 than they do now.

Furthermore, even if emerging-market ETFs have contributed marginally to the boom with their forced buying, some may soon become forced sellers.

Thanks to obscure provisions of the U.S. Internal Revenue Code and the Investment Company Act of 1940, which governs how mutual funds are organized, ETFs can't allow their assets to become over-concentrated in a handful of holdings. In general, they can't keep more than 25% of their money in a single stock, and at least half of their assets must be in securities that each account for no more than 5% of total holdings.

Now that emerging markets have risen so far so fast, these tax requirements may compel some large ETFs to begin selling their biggest holdings. Ms. Ting says that her fund automatically sells some of its Petrobras holdings, currently 23% of assets, whenever they near the 25% threshold. They are replaced, she says, with "securities with similar risk factors."

Under the same tax rules, other ETFs can be forced to trim some of their largest holdings as well. A sampling of the companies that may get automatic haircuts if emerging markets rise much higher: Samsung Electronics, which is more than 19% of the $2.8 billion iShares MSCI South Korea Index fund; shares of Copec, Endesa and Enersis in the $247 million iShares MSCI Chile Investable Market Index fund; and Sberbank, Rosneft and OAO Gazprom in the $1.2 billion Market Vectors Russia ETF.

Vinicius Silva, an analyst at Morgan Stanley, calculates that emerging markets are trading at 12.9 times their expected earnings over the next year. Since 1993, that average has been 12.8 times earnings. Emerging markets as a whole are neither a bubble or a bargain.

So what does all this mean for investors? ETFs probably haven't caused a bubble, and they might even help a bit to prevent one from forming. But many will remain superconcentrated bets on very risky markets. If you invest in an ETF with most of its assets in a few stocks and think you have made a diversified bet, the real bubble is the one between your own ears.



[www.BeatingBuffett.com]

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