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Are There Better Emerging-Markets ETF Choices?

We look beyond the market-cap-weighted giants in search of a better beta among this growing crop of exchange-traded funds.

Patricia Oey, 03/23/2013

Many investors are aware of the inherent drawbacks of exchange-traded funds that track cap-weighted emerging-markets-equity indexes. Funds such as iShares MSCI Emerging Markets EEM and Vanguard Emerging Markets VWO have large exposures to state-run firms and global macro-driven sectors such as technology, energy, and materials. As such, they don't offer meaningful exposure to those sectors that are most leveraged to local growth trends, such as consumer and industrial firms. While we have been fans of WisdomTree Emerging Markets Equity Income DEM as an alternative to its cap-weighted cousins--in large part because its dividend-weighted approach has produced better risk-adjusted returns over the last five years--we previously highlighted that this fund may be in for a bumpier road ahead.

Among actively managed mutual funds in the category, three funds with a Morningstar Analyst Rating of Silver--Oppenheimer Developing Markets ODMAX, Aberdeen Emerging Markets ABEMX, and Virtus Emerging Markets Opportunities HEMZX--have recently closed or will soon close to new investors. We tend to view such closures favorably, as a couple of years of strong inflows can make it difficult for active managers to effectively implement their strategies. So, in an environment where the biggest ETFs aren't necessarily offering the best exposure, our perennial favorite in the ETF space is looking a bit more risky, and some of the better actively managed mutual funds are turning away new investors, what are some other options for investors seeking exposure to emerging-markets stocks?

Smoother Sailing?
There has been a lot of interest in low-volatility strategies lately, driven in part by the 2008 financial crisis and its lingering fallout. There are currently two ETFs offering low-volatility emerging-markets equity exposure--iShares MSCI Emerging Markets Minimum Volatility EEMV and PowerShares S&P Emerging Markets Low Volatility EELV. As their names imply, these funds' indexes have exhibited lower volatility (with annualized standard deviations in the low 20% range) over the last five years relative to the MSCI Emerging Markets Index (28%). In 2008, EEMV's and EELV's benchmark indexes declined 42% and 34%, respectively, versus the MSCI Emerging Markets Index's 53% decline. Taking some of the sting out of market sell-offs may lead to improved returns, as investors may be less likely to sell during bear markets if these strategies' drawdowns are relatively smaller. Conversely, these strategies likely will underperform during strong bull markets. While it may be difficult to hang on to a cap-weighted index during large market declines, it may be equally difficult to sit tight in a low-volatility strategy when other funds are participating more fully in market rallies.

The idea that low-volatility strategies outperform over full market cycles would seem to upend the capital asset pricing model (CAPM) and the commonly held belief that that assuming greater amounts of risk will result in greater returns. In practice, low-volatility strategies historically have generated better risk-adjusted returns relative to their corresponding cap-weighted indexes over the long term. As such, these two funds could be suitable core holdings for an emerging-markets-stock allocation.

For investors interested in learning more about low-volatility strategies, we suggest reading "Making Sense of Low Volatility Investing," by Feifei Li of Research Affiliates. Li provides a well-written summary on the academic research, historical performance, and potential diversification effects of low-volatility strategies. Also worth a read is "The Low-Volatility Effect: A Comprehensive Look" by Aye M. Soe of S&P Dow Jones Indices. Soe's article covers similar ground and also examines the performance of low-volatility strategies in emerging markets.

In United States markets, the outperformance of low-volatility strategies can be partially attributed to the small-cap and value effect. This is not necessarily true in emerging markets--at this time, both EEMV and EELV have slight growth tilts. And while the average market cap of these funds' portfolios is about $10 billion versus about $20 billion for the MSCI Emerging Markets Index, this difference is partly due to the fact that the low-volatility portfolios have relatively less--if any--exposure to the government-controlled large caps that comprise a substantial portion of the MSCI Emerging Markets Index.

You Say Minimum Volatility, I Say Low Volatility
EEMV and EELV track different indexes and employ different methodologies, yet they have generated very similar historical returns. EEMV's index (MSCI EM Minimum Volatility Index) seeks to create a minimum variance (or lowest volatility) portfolio of 200 holdings culled from the MSCI Emerging Markets Index, using an estimated security covariance matrix and a number of constraints to limit turnover and to ensure investability and sector and country diversification. EEMV launched in October 2011, and over the trailing 12 months to Feb. 28, 2013, this fund's net asset value trailed its index (adjusted to reflect foreign withholding taxes on dividends) by only 20 basis points, which is less than the fund's 0.25% expense ratio. The portfolio is rebalanced twice a year, in May and November, and the turnover ratio over the last year was 31%. The one downside to this strategy is that the index methodology is not transparent.

Turning to EELV, this fund's index (S&P BMI Emerging Markets Low Volatility Index) seeks to create a low-volatility portfolio by employing a simple rule--it selects the 200 least-volatile stocks from the S&P Emerging BMI Plus LargeMidCap Index and weights each holding by the inverse of its volatility (the standard deviation of daily price returns over the trailing 252 days). This fund's benchmark employs the same methodology as the popular PowerShares S&P 500 Low Volatility SPLV.

Patricia Oey is an ETF analyst at Morningstar.
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