Emerging-Markets Investors Could Use Some Style

Investors have heeded the call for international diversification within their asset allocations over the last decade. Along with already strong positions in international-developed markets exposure, most investors have introduced emerging-markets funds into the mix. While we understand the impetus behind adding emerging markets to the portfolio, we find it curious that the overwhelming majority of assets migrating to the space have come in the form of purely passive, cap-weighted investments.

Most of the assets in emerging-markets exchange-traded funds are in iShares MSCI Emerging Markets EEM and Vanguard Emerging Markets VWO, two funds that track the capitalization-weighted MSCI Emerging Markets Index. In fact, these two ETFs rank as the fourth- and third-largest ETFs on the market today, amassing approximately $85 billion combined. As my colleague Greg Wolper pointed out in an article earlier this month, VWO, a fund devoted solely to emerging markets, is now larger than every broad-based international fund but three. And it's 3 times larger than the biggest actively managed emerging-markets fund.

One could argue that the size of VWO and EEM is a direct result of performance-chasing. That may or may not be true, but if investors truly have been looking for the hot commodity in the emerging-markets space, then they have been turning over the wrong stones. The three- and five-year annualized performance of the index these funds follow has been lower than those of other emerging-markets indexes that use different types of construction methodologies. Small-caps and value stocks have outperformed the broad, cap-weighted MSCI Emerging Markets Index, a trend we generally see in U.S. equities over the longer holding periods. In other words, style still matters regardless of which region you invest.

A Mega-Cap Problem?
A main issue with the MSCI Emerging Market Index is the fact that some of the largest companies by capitalization are partially government owned, particularly in the financial and energy sectors, which are the top-two sector weightings at 24% and 15%, respectively. At times, these partially government-owned entities (such as Petrobras, PetroChina, Sberbank, Gazprom, and China's big-four banks) may put political goals ahead of profitability. In addition, government policy for certain sectors, such as energy, can be driven by national interests--this could negatively affect the companies in those sectors. Less exposure to these government-owned large-caps is one reason why other emerging-markets funds/indexes have outperformed the MSCI Emerging Markets Index.

Another attribute of equal weighting is that the resulting sector weightings differ from those of a cap-weighted index. Energy, a sector which generally is the most exposed to political risk, accounts for 6% of the equal-weight index versus 15% in the cap-weighted index. And sectors more exposed to domestic-growth trends (rising standards of living and infrastructure spending)--such as consumer discretionary (10% in equal weighting versus 6% in cap-weighting), consumer staples (8% versus 5%), and industrials (14% versus 6%)--all carry heavier weightings in the equal-weight index. Country weightings in the equal-weight index are fairly similar to those of the cap-weighted index, but notable differences include Brazil (9% in equal weighting versus 16% in cap-weighting), Taiwan (16% versus 11%) and Russia (4% versus 7%). However, we highlight that with quarterly rebalancing and lower liquidity among some emerging-markets equities, this fund could see greater tracking error and/or possible capital gains distributions.

Emerging-markets style funds are also a relatively new product. Earlier this year, Global X launched Global X Russell Emerging Markets Value EMVX and Global X Russell Emerging Markets Growth EMGX. The Global X funds track the Russell Emerging Markets MegaCap Value and Growth Indexes, which screen and rank stocks using two factors: book/price ratio and long-term earnings per share, or EPS, forecasts. As in the U.S. markets, academic research has shown that over the long term, the value premium also exists in international markets. Recent historical return data for the Russell Emerging Markets Value Index and the MSCI Emerging Markets Value Index (included in Table 1) does show that the value indexes outperformed their corresponding cap-weighted indexes. The Russell style indexes are reconstituted annually in June, and it is important to note that these indexes can change significantly from year to year. At this time, EMVX's heaviest sector weighting is energy at 45%, which, as we mentioned earlier, is exposed to political risks. In addition, EMVX's heaviest country weighting is Russia (27%), which is one of the more volatile emerging markets. And while U.S. value funds tend to have heavy weightings in the financial sector, in EMVX, financials account only for 11%. So, while a value fund might sound like a less risky option, EMVX could be more volatile than expected. EMVX and EMGX could also face issues similar as EMEW regarding tracking error and capital gains distributions. For better "value" exposure, we would recommend WisdomTree Emerging Markets Equity Income Fund DEM, which is currently a 5-star fund (click here for our ETF rating methodology). This fund weighs its components by annual cash dividends paid, which is easily measurable across countries (as opposed to price/book ratios, where book values can vary because of differences in accounting standards across countries). We also expect DEM's weighting methodology to result in fewer changes in portfolio holdings at its annual rebalance, relative to EMVX.

For "better" exposure to domestic growth trends in emerging markets, investors have been turning to small-cap funds such as WisdomTree Emerging Markets Small Cap Dividend DGS and SPDR S&P Emerging Markets Small Cap EWX. While funds such as VWO have significant exposure to large multinational technology, energy, and materials firms, which tend to be driven by global macroeconomic trends, a small-cap fund such as DGS has higher exposure to the consumer and industrial sectors, which are more leveraged to domestic-growth trends. Emerging Global Shares Dow Jones Emerging Markets Consumer Titans ECON, a relatively new fund, is a solid option for exposure to rising living standards. This fund holds firms such as AmBev ABV and FEMSA FMX, and companies in subsectors such as retail, auto manufacturing, and travel and leisure. This fund has a large exposure to Latin America, with Mexico and Brazil accounting for 21% and 17%, respectively, of the portfolio. This fund also  holds only 30 stocks and is fairly concentrated, with the top-10 holdings accounting for almost 60% of the portfolio.

In 2010, investors poured into emerging-markets ETFs, but in 2011, they are starting to rush out of this asset class. There are a number of concerns that will definitely drive volatility in the near term: rising inflation and central banks' actions to contain it; rising food costs and its negative effect on consumer demand; the possibility of more political uprising in other countries, following the unrest in Egypt; and fund flows out of the asset class. However, the growth outlook for emerging markets is expected to be significantly higher than those in the developed markets over the medium and long term. As such, we would recommend a small holding in emerging market equities for long-term investors.

Patricia Oey is an ETF analyst with Morningstar.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.