Factor Investing in Emerging Markets

Note: This article is part of Morningstar's December 2013 Emerging-Markets Week special report. It originally appeared in the December/January 2014 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.

 Vanguard FTSE Emerging Markets ETF (VWO) and  iShares MSCI Emerging Markets (EEM) are by far the largest emerging-markets funds. Thanks in part to their excellent liquidity, they are often used as short-term holdings, for cash equitization, or for speculation.

But most long-term investors who have an interest in emerging markets know that these ETFs are not the best funds to capitalize on the long-term growth opportunity in emerging markets, due to their market-cap-weighting approach. These funds are heavily weighted in China and Brazil, countries that are currently facing slowing growth. The largest firms in these countries also tend to be government-controlled companies, which at times may have to put political goals ahead of profitability. And the funds' technology holdings, although they include many privately owned Taiwanese and Indian firms, are generally companies that serve a global marketplace and are less driven by trends in emerging markets.

Cap weighting also results in a relatively lower weighting of consumer firms, which account for 17% of the MSCI Emerging Markets Index, compared with 23% in the S&P 500. In summary, cap-weighted funds have less exposure to the most significant trends in the emerging markets--the rise in domestic consumption driven by an expanding middle class.

Over the past few years, we've seen the launch of a number of emerging-markets ETFs that seek to exploit factors such as small cap and low volatility. Like in the United States, these factors have been shown to deliver better risk-adjusted returns in emerging markets over the long run. But aside from these premiums, these strategies also avoid some of the aforementioned drawbacks of cap weighting, in that they have less exposure to government-controlled entities and greater exposure to firms tied to the local economies.

Although these funds may offer better exposure to emerging markets, they also come with a unique set of issues. First of all, many of these funds, and their indexes, have short track records. Second, these funds rebalance periodically, and at times, the portfolio can change significantly. So although these funds are considered "passive strategies," investors should monitor these holdings more carefully. Finally, there are many moving currents in emerging markets, such as currency volatility, government intervention into the private sector, and large-scale reforms. These issues not only have an impact on fund performance, but they can also impact portfolio construction, as these funds employ a number of rules for security selection. 

Below, we highlight our picks among the passively managed, rules-based emerging- markets ETFs.

WisdomTree Emerging Markets Small Cap Dividend
The primary investment case for emerging-markets small caps, aside from the small-cap premium, is that they offer better diversification benefits relative to large caps, as smaller companies tend to have more exposure to local economies and customers. Our pick is  WisdomTree Emerging Markets Small Cap Dividend (DGS). 

Although small caps usually connote higher risk, DGS' volatility has been lower than that of the large-cap benchmark MSCI Emerging Markets Index over the past five years. This is because DGS has somewhat of a quality tilt thanks to its dividends-paid weighting methodology. (Dividends can serve as a proxy for effective management and healthy fundamentals.) And although U.S. small caps can be young, speculative firms with little or no profitability, in the emerging markets, small caps tend to be well-known, established players in their respective countries. In addition, like many dividend funds, DGS 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, DGS has provided higher absolute and risk-adjusted returns over the MSCI Emerging Markets Index.

DGS' dividend-weighted strategy has resulted in fairly stable country and sector allocations, although we note that this fund has had a relatively short history. Relative to the MSCI Emerging Markets Index, DGS overweights stocks from Taiwan, Thailand, Malaysia, and Turkey, and underweights stocks 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 sectors, 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, although cap-weighted small-cap funds often have high turnover as securities move out of specified market-cap thresholds, DGS' dividend approach has resulted in lower turnover during its annual reconstitution in June. This is particularly important in an asset class with relatively limited liquidity, such as emerging-markets small caps. 

IShares MSCI Emerging Markets Minimum Volatility
There has been a lot of interest in low-volatility strategies lately, driven in part by the 2008 financial crisis and its lingering fallout. Two ETFs offer 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 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 compared with that in U.S. equities. This is especially important in emerging markets, as volatility drag can have an impact on long-term performance.

As a result of this reduced volatility, in 2008, EEMV's and EELV's benchmark indexes declined 42% and 34%, respectively, versus the MSCI Emerging Markets Index's 53% decline. This relatively muted decline in 2008, as well as in 2011, were key drivers of the low-volatility strategies' outperformance over the last five years. However, these return and volatility data include hypothetical historical performance, as both indexes were launched after 2008. Investors should always take back-tested data with a grain of salt.

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. Although 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 in the MSCI Emerging Markets Index.

It is important to note that 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 investability screens could be very costly to replicate and drag on the performance of the fund relative to its index.

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. Both funds are about two years old, and since inception, the iShares fund has tracked its index much more closely than the PowerShares fund, which suggests that the MSCI index may be more investable. To address the tracking issue in the PowerShares fund, S&P introduced a liquidity threshold to its index at the end of 2012. While the fund has subsequently performed more in-line with its underlying index, we think this type of index tweaking suggests the benchmark was initially created without acknowledging some of the unique and subtle issues related to investing in emerging markets.

The iShares fund tracks an index that is a minimum variance portfolio of 200 holdings culled from the MSCI Emerging Markets Index. It 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.

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