(In para 4 corrects AUM of EM funds to $900 billion)
By Sujata Rao
LONDON, Sept 14 (Reuters) - The global fund management industry is a potential source of risk for emerging markets because of its vast size and herd-like investor behaviour that can exacerbate asset price fluctuations, a BIS report said on Sunday.
In its quarterly review, the Bank for International Settlements said the selloff that rocked emerging economies last year was a reminder of how "the activity of large asset managers can significantly affect small and illiquid asset markets".
The presence and influence of asset managers in emerging market economies (EME) has grown significantly in recent years, BIS said, citing data showing emerging bond funds alone had quadrupled assets under management (AUM) between 2007 and end-2013.
The total AUM of emerging market funds tracked by the Boston-based EPFR Global consultancy has risen to $1.4 trillion from $900 billion before the Lehman crisis, it added.
While these amounts are dwarfed by the AUM of funds dedicated to the United States or Europe, they are large relative to emerging stock and bond markets.
"The large size and concentration of AUM of asset managers in relatively small and illiquid EME asset markets are a potentially important source of concern. Any decision by asset managers with large AUM to change portfolio allocation can have a major impact on EME asset markets that are relatively small," BIS said in its report.
While acknowledging the benefits of foreign investment for developing countries, BIS noted that successive crises over the years had highlighted how investors may destabilise EME asset markets - "accentuating both booms and busts".
The problem was exacerbated by fund managers' use of common or similar benchmarks, BIS said, referring to stock and bond indexes against which investors measure their performance.
In emerging bond markets for instance, JPMorgan indexes tend to be most widely used, while equity index provider MSCI says $1.4 trillion is benchmarked to its main emerging equity index.
The BIS report noted the growing popularity of "passive" investing via so-called ETFs that mirror the benchmark index. But even in the case of actively managed funds, the use of common benchmarks or a high degree of correlation between benchmarks may lead fund managers to adopt similar asset allocation strategies, it warned.
"These funds are likely to move in the same direction and react in similar ways when they face EME-related shocks," the report added, citing the example of 2013 when the prospect of tighter U.S. monetary policy saw tens of billions of dollars flee emerging market funds.
BIS cautioned earlier this year that as regulators clamped down on risk-taking by banks, the role of asset managers in funding lower-rated companies and sovereigns had grown, a potential danger for the global financial system.
This carries risks for emerging markets too.
The latest BIS quarterly report highlighted rising debt issuance by private sector emerging market borrowers. These have raised debt worth almost $375 billion in 2009-12, it said, more than double what was sold in the four years before the crisis. What's more, much of this is in foreign currency debt.
It added: "There is reason to believe that many EME corporates are unhedged against this exposure. Together with their increase in leverage, this raises the vulnerability of EME corporates to the combined effects of a domestic slowdown, currency depreciation and a global rise in interest rates." (Reporting by Sujata Rao; Editing by Susan Fenton)