Turkish ETF plunge shows one of the biggest risks with emerging markets

Turkish ETFs have lost a lot of value on the back of the Turkish lira’s share devaluation. 

The Turkish lira plunged in value by around 15% at the end of the weekend. The trigger was Turkish president Recep Tayyip Erdogan firing yet another central bank governor. This was the fourth time a central bank governor has been fired by the president since 2014, compounding a sense of economic mismanagement among international investors.

The lira has been wracked by volatility in recent years. Partly this has been the result of Erdogan’s central bank interference. Notably, in 2018, the president shocked investors by stating that interest rate rises are bad for inflation, going against economic orthodoxy. The lira also struggled in 2020 due to foreign policy disputes with Greece and other EU members.

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However, until the recent central bank firing, the Turkish lira had been in recovery mode, being one of the best-performing emerging market currencies when measured against the dollar in 2021. Indeed, just last week the lira saw strong gains after the now-fired central bank governor raised interest rates by two percentage points, twice what economists were predicting.

The recent plunge in the value of the lira has been bad news for investors in the Turkish equity-focused ETFs we have on interactive investor. On a one-day basis, using interactive investor figures, the HSBC MSCI Turkey ETF (LSE:HTRD) closed down 18.5% on 22 March. Meanwhile, both the iShares MSCI Turkey ETF USD Dist GBP (LSE:ITKY) and the Lyxor MSCI Turkey ETF Acc GBP (LSE:TURL) have lost around the same.

The news has obviously weighed heavily on Turkish stocks. For example, the Istanbul 100 index, according to Bloomberg, was down by around 10%. However, it is important to note that a large chunk of the losses experienced by the above-mentioned ETFs has been the result of the plunge in the value of the currency itself. These ETFs use either the US dollar or sterling as their base currency. However, the underlying assets are all ultimately valued in lira. When the value of the lira falls, so too do the value of the stocks when valued in other currencies.

We can see this phenomenon over a longer time frame. According to data from FE Analytics, the MSCI Turkey index is up around 60% in local currency terms over the past five years. Therefore, those based in Turkey who bought the MSCI Turkey index with Turkish lira, and were happy to have returns stay in Turkish lira, would have in theory made a decent return. In theory, because this does not account for the sustained domestic inflation the Turkish economy has experienced over this time period.

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However, for investors outside Turkey, who do not want their returns in Turkish lira, the losses have been substantial. So, for example, in sterling terms, the MSCI Turkey index is down by around 30% over five years. Likewise, both the HSBC and iShares ETFs tracking the index experienced losses of around the same amount over the past five years in sterling terms.

This serves as a good reminder of the risks associated with investing in emerging market economies with potentially volatile currencies.

You can also see this in other emerging market economies that have been hit by volatility in recent years. For example, the MSCI Brazil Index is down by 18% in local currency terms over the past two years. However, convert that into sterling and returns sit at a loss of 22% owing to the steady depreciation of the value of the Brazilian real over that period.

Investing in emerging markets can be lucrative, but keep in mind that domestic political and institutional instability is an ever-present risk and can lead to significant drops in the value of currency. And, as we have seen with Turkish ETFs, that can have a substantial impact on your returns.