This ETF provides broad and low-cost exposure to an attractively valued market.
IShares Core MSCI Emerging Markets IEMG offers broad exposure to large-, mid-, and small-cap companies across 23 emerging markets, including Taiwan and South Korea. Its rock-bottom fee and inclusion of small-cap companies set it apart from its peers in the diversified emerging-markets Morningstar Category. Its market-cap-weighting approach promotes low turnover but also creates significant exposure to individual country risk.
Despite the inclusion of 23 emerging markets, China (26%), South Korea (15%), and Taiwan (13%) jointly account for more than half of the portfolio, owing to their large relative size. The same three countries make up less than 40% of the typical actively managed fund in the category. MSCI, the firm behind the fund's index, is also considering adding China A-Shares, which would further increase the fund's allocation to Chinese stocks.
The fund's broad portfolio effectively diversifies company-specific risk. The top 10 holdings account for less than 20% of the portfolio, compared with 30% for the average category peer. These include Samsung Electronics SSNLF, Alibaba Group BABA, and several Chinese banks. Small-cap companies account for a small sliver of the portfolio, which adds a modest diversification benefit. They tend to be more highly leveraged to their local markets than their larger counterparts.
From its inception in October 2012 through August 2016, the fund underperformed the category average by 26 basis points annualized, but its sizable cost advantage should give it an edge over the long term. During the trailing 10-year period through August 2016, using the fund's benchmark (MSCI Emerging Markets Investable Market Index) less its 0.16% fee as a proxy, it would have outpaced the category average by 60 basis points annualized, besting nearly two thirds of its category peers with similar volatility.
Like most of its peers, this fund does not hedge its currency risk, which can hurt performance when the U.S. dollar strengthens relative to foreign currency and tends to increase volatility. During the trailing 10-year period through August 2016, nearly one fifth of the fund's total volatility came from currency fluctuations.
Strong economic growth forecasts are often cited as a rationale for investing in emerging markets, but such growth has not translated into superior stock performance historically for several reasons. First, many of the larger firms listed in emerging markets generate a significant portion of their revenue and income abroad. This means that their profits can grow at a different rate than the domestic economy. Second, publicly traded companies often grow at a slower rate than their local economies because privately held companies drive a lot of that growth. Additionally, poor corporate governance in some emerging markets can lead to dilution of corporate earnings through new stock issuance.
Valuations also matter. From 2001 to 2010, emerging markets handily outperformed developed markets. At the beginning of this period, emerging-markets valuations were below their historical average following several financial and political crises, while the valuations in the U.S. stock market were high following the historic 1990s bull market. Recently, emerging-markets valuations have lowered relative to developed markets. During the trailing 10-year period through August 2016, the average difference in trailing 12-month P/E ratios for the MSCI World Index relative to the MSCI Emerging Markets Index was 2.7, showing emerging markets tend to trade at a lower valuation than developed markets. At the end of August 2016, the difference was 5.0, indicating emerging-markets valuations relative to developed markets are currently lower than their trailing 10-year average.
This fund offers a good way to get exposure to emerging-markets stocks. Its market-cap-weighting approach promotes low turnover and skews the portfolio toward large multinational firms. These companies tend to be more profitable and less volatile than their smaller counterparts. However, some of the fund's largest holdings are state-owned enterprises, which may be forced to prioritize political objectives over profit maximization. The fund's sector weightings are similar to the category average, but the fund has greater exposure to technology and less exposure to consumer defensive companies. Financial services and technology are the two largest sectors; each represent a little more than one fifth of the portfolio.