Emerging markets ETFs that employ factor investing methodolgies avoid some of the drawbacks of cap-weighted approaches. Here are our top picks.
The Vanguard FTSE Emerging Markets
But over the past few years, many investors have come to realize that those two funds aren’t the best vehicles for exposure to the long-term growth opportunities in emerging markets, because of their market-capitalization weighting methodologies that tilt them toward large-cap stocks. That’s because many of the largest companies in countries such as China, Brazil, and Russia are state-controlled firms that at times put political goals ahead of profitability. In addition, the ETFs’ technology allocations, which account for about 15% of their portfolios, consist mostly of hardware and IT services companies that serve a global market place and are less driven by local market trends. Cap-weighting also results in a relatively low weighting of consumer firms—companies most likely to benefit from growth in domestic consumption.
Recently, there have been a number of newly launched ETFs that seek to improve on market-cap weighted approaches by exploiting investment factors. Like they have in the United States, these factors—small cap, value, and volatility—have produced strong risk-adjusted returns over the long term in emerging markets. These strategies also address some of the drawbacks of cap-weighting. They reduce exposure to government-controlled entities and bring greater exposure to firms tied to local economies.
While these funds may offer a better exposure to emerging markets, they also come with their own set of risks. First, many of these funds and their underlying indexes have short track records. Second, these funds periodically rebalance, which can lead to significant portfolio changes. Rebalancing isn’t always a problem, but it will require more monitoring by investors. (See “Following the Rules,” Page 48.) Finally, and most importantly, there are many moving currents in emerging markets, such as currency volatility, government intervention in the private sector, and large-scale reforms. These issues are unpredictable. They not only have an impact on fund performance, but they affect portfolio construction.
That said, some funds make sense in a diversified portfolio. Below, we highlight our top picks among the passively managed, rules-based emerging-markets ETFs.
WisdomTree Emerging Markets Small Cap Dividend
The primary investment case for emerging markets small-cap stocks, aside from the small-cap premium, is that they offer better diversification benefits relative to large caps because small companies tend to have more exposure to local economies and customers than do large companies.
While small caps usually connote higher risk, this WisdomTree fund’s volatility has been lower than that of the large-cap-oriented MSCI Emerging Markets Index over the past five years. That is largely due to its quality tilt, which stems from its dividends-paid weighting methodology. (Dividends can signal effective management and healthy fundamentals.) While U.S. small caps can be young, speculative firms with little or no profitability, small caps in emerging markets tend to be wellknown, established players in their respective countries.