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By Christian Charest and Patricia Oey | 10-03-2013 02:00 PM

ETF Trade Winds Changing in Emerging Markets

Although passive market-cap-weighted ETF strategies remain popular in developing markets, they do have their drawbacks, but actively managed low-volatility and value strategies are gaining momentum, says Morningstar's Patty Oey.

Christian Charest: For Morningstar, I'm Christian Charest, coming to you from the Morningstar ETF Invest Conference in Chicago. I’m here with Patty Oey, who is an exchange-traded fund analyst with Morningstar. She’s also our specialist on emerging markets.

Patty, you just moderated a session on emerging markets and several different points were brought up that were very interesting. One of the points was the fact that inflows into emerging-markets funds were still positive; they’re still positive despite the recent returns that have been less than favorable. But you mentioned that those flows are going into active strategies rather than traditional cap-weighted ETFs.

What are some of the issues with cap-weighted funds that make them less appealing for emerging markets?

Patty Oey: The two very popular funds are iShares market cap-weighted fund, and there is also a Vanguard one. I think investors are starting to realize actually that these cap-weighted funds, they do have some drawbacks. Number one, in terms of country diversification, it’s not very good. China and Brazil are relatively much larger than some of the smaller countries. So those account for a bit part of the index.

With Taiwan, Taiwan is actually not a very large economy, but it has a very large capital market. So that also tends to have a heavy weight in a cap-weighted index. So those three countries can account for about 40% to 50% of a cap-weighted, and then the remaining 20 or so countries have to share the rest of that 50%, 60%. So you’re not getting very good country diversification.

Another issue with a cap-weighting is that when you buy an S&P 500 fund, what you’re getting is U.S. blue chips, and these are very big, very successful, very well-run companies. In emerging markets, a lot of the larger companies, tend to be actually government-owned entities. When you have a government-owned entity, they’re not necessarily always focused on profitability. Sometimes they have to fulfill either political goals or economic goals, and so maybe those aren’t necessarily the best companies to invest in.

Finally, we also note that in a cap-weighted strategy, there are relatively lower weightings in companies that tend to benefit more from the general themes in emerging markets, which is rising middle class and growing domestic consumption. Cap-weighted indexes tend to have less of those types of companies that will benefit from those trends.

Charest: One of the alternatives that was talked about during the presentation was factor-based strategies, or smart beta. What did the panelists have to say about that?

Oey: With smart beta, these are kinds of factor strategies like value or low-volatility or dividend. These are all popular for developed markets, and they’re getting more popular in emerging markets. Those risk premia or those strategies actually do work in emerging markets. So we do see a small-cap premium in emerging markets. We do see a value premium. We also see a low-volatility premium. Those strategies do work. We’re starting to see them in products, and now investors can use those products.

What I would caution is that these products and the indexes, kind of have a short track record. It’s something that, I think, is interesting. I think it’s a good development. I think these products are likely to be pretty good, but it’s important for investors to kind of really understand how these products are constructed, and sometimes they have annual rebalancing or semiannual rebalancing. It’s important to monitor the portfolio and to see when the portfolio changes, is the portfolio still kind of meeting your investment criteria? It's something to watch. I think it’s a good development but still a relatively new product.

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