Last year's rebalance resulted in some significant changes in the fund.
WisdomTree Emerging Markets Equity Income DEM has long been our favorite exchange-traded fund for emerging-markets equity exposure, thanks to its significantly lower volatility relative to the MSCI Emerging Markets Index and stellar trailing five-year risk-adjusted returns. Unlike most passive funds that track a market-cap-weighted index, DEM tracks a dividend-weighted index. Once a year on May 31, the fund rebalances its portfolio, using total dividends paid by the firms in its investable universe over the past year to inform its position weightings. Last year's rebalance resulted in some significant changes to the fund’s profile, and we think DEM may be a more risky fund in the near term, relative to its recent history.
Most dividend funds weight their holdings by stocks’ dividend yield, but DEM’s methodology is different. At the May 31 rebalance, DEM’s benchmark index screens the universe of emerging-markets stocks for firms that have paid out at least $5 million in regular cash dividends over the past 12 months and have met certain market-cap and liquidity requirements. These companies are then ranked by dividend yield, and the top 30% are selected for inclusion in DEM’s index. Constituents are weighted by dividends paid, measured by trailing 12 months dividends per share multiplied by shares outstanding, converted into U.S. dollars. This methodology attempts to create a relatively high-yielding fund with a large-cap tilt (larger companies tend to pay a higher total amount of dividends) and a slight value tilt. (At the rebalance, the index tends to sell lower yielding companies and buy higher-yielding companies).
There are interesting intricacies to this WisdomTree dividend strategy, especially when applied to the emerging markets, which is a very diverse universe. For example, Taiwanese and Brazilian companies tend to be higher dividend payers due to tax rules and laws that support dividend payouts. As a result, emerging-markets dividend funds, including DEM, tend to have substantial exposure to these countries. In addition, governments can influence company dividend policies, and in turn, the composition of this fund. Finally, because DEM’s positions are weighted by dividends paid, measured in U.S. dollars, the portfolio can also be affected by currency movements.
From Russia With Love?
The most notable change to DEM’s portfolio resulting from the 2012 rebalance was the large increase in exposure to Russian stocks, which went from a low-single-digit percentage over the past few years to 13%. This represents a significant overweighting relative to the MSCI Emerging Markets Index’s 6% weighting in Russia. While Russia is currently trading at cheap valuations (the MSCI Russia Index is trading at about 5 times trailing 12-month earnings versus a five-year average of 7 times), investing in Russia is a very risky proposition--the country’s stock market has very heavy exposure to the energy sector, the ruble is extremely volatile, and corruption within Russia is rampant. Since DEM’s inception in 2007, most Russian firms have failed to qualify for inclusion in DEM’s benchmark index. However, at the 2012 rebalance, shares of state-owned natural gas monopoly Gazprom were added for the first time. Gazprom stock now accounts for a significant 7% of the portfolio after the firm more than doubled its dividend payout.
Gazprom’s hand was forced by a new rule requiring government-owned firms to pay out at least 25% of their net profits as dividends. While the government has stated that it hopes this change will attract more investment into Russia, the state also benefits as a majority shareholder in these companies. If this mandate remains in place, more state-owned firms may be added to DEM. This can be a source of risk, as state-owned Russian firms, and particularly those in the energy sector, can operate at the behest of the government to support national economic goals or the federal budget (through higher taxes) at the expense of profitability.
Banking on China
DEM’s exposure to China also spiked following last May’s rebalancing, from about 4% over the previous two years to the current 16%. The largest additions to the portfolio were China Construction Bank (now at 8%) and Industrial and Commercial Bank of China (now at 3%). These two firms, along with Bank of China (which was not a new addition) are all state-owned banks and together account for more than 13% of DEM’s portfolio. These banks have paid out relatively stable dividends over the past few years. But at the time of the 2012 rebalancing, these firms’ stocks were trading near multiyear lows, largely because of concerns about their exposure to bad loans related to the 2009 stimulus program and a deflating housing bubble. Thanks to weak share prices, these firms were sporting mid-single-digit dividend yields, which qualified them for inclusion in DEM’s benchmark index. While these banks are mega-cap companies, their combined 13% weighting in DEM is significantly higher than their 3% weighting in the MSCI Emerging Markets Index. This can be partly attributed to currency effects. The yuan was the only currency (out of all of DEM’s major underlying currency exposures) to appreciate relative to the U.S. dollar in the 12 months leading up to May 31, 2012. Because constituents are weighed by total dividends paid, expressed in U.S. dollars, these Chinese firms received a further boost in their relative weighting given the yuan’s strong performance relative to other emerging-markets currencies in the run-up to the rebalancing.
These three Chinese banks’ stocks have rallied from 20% to 30% since they have been added to DEM. If they continue their strong performance, it is possible their dividend yields will fall to the point that they will no longer qualify for index inclusion come this year’s rebalance--a perfect example of the buy low, sell high mechanism embedded in the underlying index’s methodology. Should they remain in the portfolio come the end of May, it is clear that they face a number of risks. They are still exposed to the potential of souring loan portfolios and may need to trim dividends to strengthen their balance sheets, which would negatively affect share prices. The government also plans to liberalize interest rates in an effort to stimulate competition. Such moves could threaten these banks’ highly profitable oligopoly. And like Gazprom, these banks can be called upon to “support” government initiatives as they have in the past, putting the interests of Beijing ahead of profitability.
A Carnival of Dividends in Brazil
In Brazil, regulators require companies to pay out a minimum of 25% of net earnings to shareholders. As a result, Brazilian companies tend to be higher dividend payers relative to many other emerging-markets companies. Over the past two years until the 2012 rebalance, Brazilian stocks accounted for about 20% of DEM’s portfolio. But after last year’s rebalance, Brazil’s representation in DEM’s portfolio fell to 14%, primarily due to currency effects. In the 12 months leading up the 2012 rebalance, the Brazilian real suffered the greatest decline versus the U.S. dollar among the local currencies of all of DEM’s top country holdings. The real’s decline was a factor of weak economic growth and continued government intervention in the currency market. Again it’s important to remember that currency fluctuations can have an impact on the composition of DEM’s portfolio.
Dialing Down Risk
DEM’s trailing five-year standard deviation was 24% as of December 2012, which was significantly lower than the MSCI Emerging Markets Index’s 29%. DEM’s five-year upside capture ratio (using the MSCI EAFE Index as a benchmark) of 105 was lower than the MSCI Emerging Markets Index's 119. However, its downside capture ratio was significantly lower (79) than that for the MSCI Emerging Markets Index (108). While avoiding large drawdowns is very important for the long-term performance of emerging-market funds, a less volatile fund may also help improve an investor’s experience, as investors tend to sell funds as they fall. While we think DEM’s volatility will remain below that of the MSCI Index, we are concerned about these potentially higher-risk China and Russia holdings, and the fact that DEM’s exposures in China and Russia are not diversified. In the seven months since the 2012 rebalance, we note that the volatility gap between DEM and the MSCI Emerging Markets Index has narrowed.
Other emerging-markets equity ETFs that offer lower volatility relative to the MSCI Emerging Markets Index include iShares MSCI Emerging Markets Low Volatility EEMV and EGShares Emerging Markets Consumer ECON. EEMV holds a portfolio of stocks culled from the MSCI Emerging Market Index that has the lowest absolute volatility, subject to a set of constraints to maintain diversification. Over the past 10 years, this index has provided an average of 400 basis points per year of excess return relative to its parent index, while exhibiting much lower volatility. This fund charges a relatively low 0.25% annual expense ratio. As for ECON, while sector equity funds tend to be more volatile than the broad market, this fund’s lower volatility stems for the fact that it invests in the 30 largest emerging-markets consumer companies, many of which are highly profitable firms that dominate their respective markets. This ETF charges an annual expense ratio of 0.85%.