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By Patricia Oey | 04-11-2014 05:00 PM

Lost in Translation: Emerging-Markets Dividend ETFs

The screening processes for high-quality dividend payers may not be as effective in emerging markets.

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Patty Oey: Most U.S.-equity dividend exchange-traded funds employ a number of rules to screen out distressed names. For example, there are some funds that screen for names that have consistently paid higher dividends over a certain period of time and there are other funds that will screen for companies with relatively better fundamentals. These ETFs tend to have pretty high-quality portfolios, and they're suitable for use as a core holding.

Turning to emerging markets, there is a relatively new fund; it's called Market Vectors MSCI Emerging Markets Quality Dividend, ticker QDEM. This fund is looking for dividend payers that are relatively high-quality; it tracks the MSCI Index. What it does is it looks for higher-yielding companies, and they have to pass through these screens. They have to have paid consistent dividends over the last five years and have relatively higher returns on equity, low debt/equity ratios, and low earnings variability.

After stocks pass these screens, they form the index, and the index weights everything by their market cap. This should result in slightly less turnover relative to a yield-weighted approach. Its largest allocations are China at 30%, South Africa at 15%, and Russia at 13%. Unfortunately, the Chinese and Russian holdings, the biggest ones are your usual suspects. They are the government-controlled large-cap Chinese banks and Russian energy companies, and these companies right now have a pretty murky medium-term outlook. As a result it's not surprising that they're trading at relatively high yields because their share prices are quite depressed.

South Africa on the other hand has a lot of high-quality companies, and a lot of these companies have exposure to their faster-growing neighbors on the African continent. The South African rand was really volatile last year, and things are settling down. But it does highlight a risk that this fund has not hedged its foreign-currency exposure. So when emerging-markets currencies are falling, it will not only impact the share price of the ETF but will also impact the dividends that are paid out because the dividends are paid out in U.S. dollars.

The takeaway here is that quality screens that work well with U.S. equities may not work that well in emerging markets.

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