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.
The fund’s dividend focus also means it has a value tilt, which may benefit long-term investors, as the value premium has also been observed in emerging markets. Since inception six years ago, the fund has provided higher absolute and risk-adjusted returns than the MSCI benchmark.
We also like how the fund’s dividend-weighted strategy has resulted in fairly stable country and sector allocations. Relative to the MSCI Emerging Markets Index, the fund is overweight stocks from Taiwan, Thailand, Malaysia, and Turkey, and underweight companies from China, Brazil, India, and Russia. These country tilts are somewhat driven by the availability of investable, dividend-paying small caps in each country.
As for sector exposures, this fund has greater exposure to industrial and consumer firms and less exposure to financials and energy firms relative to the MSCI Emerging Markets Index. Also, while cap-weighted, small-cap funds often have high turnover as securities move out of specified market-cap thresholds, This fund’s dividend approach has resulted in lower turnover during its annual reconstitution in June. This is particularly important in an asset class with relatively lower liquidity.
iShares MSCI Emerging Markets Minimum Volatility
The 2008 financial crisis and its lingering fallout have created interest in low-volatility strategies that are designed to minimize dramatic ups and downs in performance. Two ETFs that offer low-volatility emerging-markets equity exposure are iShares MSCI Emerging Markets Minimum Volatility and PowerShares S&P Emerging Markets Low Volatility EELV.
As their names imply, these funds’ indexes have exhibited lower volatility (with annualized standard deviations around 20%) over the past five years relative to the MSCI Emerging Markets Index (26%). Thanks in part to the heterogeneity of the emerging-markets equity asset class, low-volatility strategies result in greater volatility reduction relative to a cap-weighted index when compared with low-volatility strategies in U.S. equities. This is especially important in emerging markets, as volatility drag can have an impact on long-term performance.
The reduced volatility has helped the funds’ benchmarks avoid big losses. In 2008, the iShares and PowerShares underlying indexes declined 42% and 34%, respectively, versus the MSCI Emerging Markets Index’s 53% decline. These indexes exhibited relatively muted declines again in 2011, when the cap-weighted index stumbled. Those two years are key drivers of the low-volatility strategies’ outperformance the past five years.
In U.S. equities, the outperformance of low-volatility strategies can be partially attributed to the value and small-cap effect. However, in emerging markets, low-volatility strategies have less of a value and small-cap tilt. The iShares and PowerShares funds have average market caps of around $10 billion versus $20 billion for the MSCI index. That is partly due to the fact that low-volatility portfolios have relatively less exposure to the government-controlled mega-cap stocks.
These strategies can have high turnover and can include securities that are not that liquid. With higher transaction expenses in emerging markets, a low-volatility index without appropriate liquidity and investment screens could be very costly to replicate and drag on the performance of the fund relative to its index. We note that both of the indexes were created after the global financial crisis, so longer-term historical data reflect hypothetical performance. Investors should consider funds that track an index by a provider with an established track record in emerging markets.
In that regard, we prefer the iShares fund, which tracks an MSCI index, over the PowerShares fund, which tracks an S&P index. MSCI incorporates a number of investability screens to its indexes, and it is the index provider of choice for institutional investors in emerging markets. Both funds are about two years old, and since inception the iShares fund has tracked its MSCI index more closely than the PowerShares fund has tracked its S&P index. That suggests that the MSCI index may be a more investable index.
The iShares fund is reconstituted twice a year in May and November. The index it tracks is a minimum variance portfolio of 200 holdings culled from the MSCI Emerging Markets Index. The iShares fund has heavy weightings in Taiwan, China, and South Korea, and in financials, consumer staples, and telecoms. The index has constraints to limit turnover and to ensure country and sector diversification, so we do not expect this fund’s portfolio to change significantly during its semiannual reconstitution or exhibit very high turnover.
S&P addressed the performance lag issue one year after the PowerShares fund launched by introducing a liquidity threshold to the index to improve its investability. While the fund has subsequently exhibited much better tracking, we think this type of index tweaking suggests that the index was initially created without acknowledging some of the unique issues related to investing in emerging markets.