The return characteristics of size and style still hold true outside of the United States.
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
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
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
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.