WisdomTree Emerging Markets--Rebalance Results in More Russia

Last week, WisdomTree disclosed the rebalanced portfolio of the 5-star rated  WisdomTree Emerging Markets Equity Income (DEM), which will be implemented following the close of trading on Friday, June 21. DEM's dividend-weighting strategy has resulted in an annualized 450-basis-point outperformance relative to the cap-weighted MSCI Emerging Markets Index over the past five years to May 2013. Part of this performance was due to DEM's quality tilt, as demonstrated by its lower volatility. During the 2008 global financial crisis, DEM's total drawdown was 46.7% versus the MSCI EM Index's decline of 58.8%.

Earlier this year, in my article "Is Our Favorite Emerging-Markets Equity ETF Getting Riskier?" I noted that following DEM's June 2012 rebalance, its portfolio had changed significantly. Most notably, Russian stocks had risen to 13% of the portfolio, from an average of 2% over the prior three years. Chinese stocks also jumped--to 16% from 3% over the prior three years--due primarily to the addition of two large state-owned banks. With DEM's large allocations in Russian stocks and Chinese banks following its 2012 rebalance, I was concerned that volatility was going to rise, which turned out to be the case. Over the past year, the fund's monthly standard deviation of returns was 8.8%, which was only slightly lower than the MSCI EM Index's 9.3%. This compares unfavorably with DEM's much lower annualized five-year standard deviation of 23.3%, versus the MSCI EM Index's 28.0%. DEM also underperformed the MSCI EM Index by about 150 basis points over the past year.

Following the 2013 rebalance, Russian stocks will comprise an even larger piece of DEM. This trend is the result of a ruling announced last year that state-owned firms are to pay at least 25% of net income in dividends. The intended outcome of this ruling was to boost foreign investor interest in Russian stocks, lift valuations ahead of the government's plan to sell some of its shares in state-owned firms, and provide much-needed additional revenue into public coffers. For the year to date, Russian stocks are underperforming the MSCI EM Index because of uncertainty regarding these dividends, Gazprom's (Russia's largest company as measured by market capitalization) weak share price performance, and resurfacing concerns about the rights of minority shareholders in Russia.

The government's new dividend policy in Russia is not yet seeing its intended results, particularly in the area of improving share price performance. While investors had been expecting Russian companies to calculate this year's dividend payout ratio on profits based on International Financial Reporting Standards, some companies elected to use Russian Accounting Standards to calculate their net profit. The main difference between the two methods is that IFRS requires companies to consolidate results, whereas RAS does not; thus, profits, and therefore dividends, under RAS tend to be substantially smaller. We also note that not all companies are complying with the dividend rule. Large-cap banks such as Sberbank and VTB are not hitting the 25% payout ratio this year in order to meet their capital requirements.

State-owned natural gas monopoly Gazprom, on the other hand, announced in early 2012 that it was going to more double its dividend payout; as a result, it became DEM's largest holding at 7% of the portfolio, following the 2012 rebalance. Unfortunately, since June 2012, plenty of bad news has had a negative impact on Gazprom's shares--plans by the government to raise taxes on the energy industry to help balance the budget, ballooning expenses on the construction of a foreign-policy-motivated South Stream pipeline (to serve European customers who have been increasing diversifying away from Gazprom to cheaper alternatives), and deeply entrenched corruption and waste. The Peterson Institute for International Economics, a think tank, estimates that although Gazprom posted nominal profits of $46 billion in 2011, it lost $40 billion to corruption and inefficiency. Gazprom may be an egregious model, but it can serve as an example of the risks of investing in state-owned firms. Over the past year, the London-listed Gazprom ADR (for Russian exposure, DEM only holds London-listed shares of Russian companies) has been down 27%. Following the 2013 rebalance, Gazprom will be one of DEM's top holdings, accounting for around 5% of the portfolio.

Perception of corporate governance in Russia took another step back a couple of weeks ago when state-owned oil firm Rosneft, which completed its purchase of TNK-BP in March, announced it would not pay any dividends this year to minority shareholders of TNK-BP Holdings. Rosneft says it doesn't have to pay dividends to minority shareholders, who are mostly long-term foreign investors, because the ownership of TNK-BP was in transition last year. This move added insult to injury, as Rosneft did not offer to buy out the minority shareholders when the acquisition was announced last October. Rosneft will be a new addition to DEM following this year's reconstitution, and will be the third-largest holding, at around 4%.

Russia is currently trading at a trailing 12-month price/earnings ratio of 5 times versus the MSCI EM Index's 12 times; this discount is almost the largest it has been over the past six and a half years. Russian stocks may be cheap enough for very risk-tolerant, long-term investors, but in the near term this fund's Russia overweighting may be an anchor. Russian stocks may also continue to grow as an allocation within DEM over the next few years as the government contemplates raising the dividend payout ratio to 35% by 2015.

Turning to China, shares of the big four state-owned banks performed well over the past year to May 2013, rising 21% to 30%. These banks accounted for 13% of the portfolio following the 2012 rebalance and will account for about 10% after this year's rebalance. While investors continue to be concerned about the rise of nonperforming loans and the impact of interest-rate liberalization, the big four banks seemed to prove the naysayers wrong by delivering strong 2012 results, which have helped support share prices. However, the 10%-20% rise in profitability across the four firms was driven by loan growth, primarily for infrastructure projects, real estate and key manufacturing sectors (areas which have seen over-investment over the past decade), and the fast-growing wealth-management product business aimed at retail investors. Nonperforming loans remained flat in 2012, partially due to the fact that regulators have allowed banks to roll over many of the loans that are overdue to local governments. Some local governments have refinanced these loans by issuing bonds, which in turn have turned up as assets backing new wealth-management products.

According to the China Banking Regulatory Commission, wealth-management products have grown from close to zero a few years ago to $1.2 trillion at the end of 2012. These short-term, high-yielding products pool together customer funds and invest the money into different types of assets, some of which may have long-term maturities. Regulators have not been able to successfully track where exactly these funds are going and recently introduced some new rulings on how the assets should be managed and what types of disclosures are required. As the economy slows, it may become increasingly difficult for these Chinese banks to continue their maneuverings and sustain strong operational performance. In a worst-case scenario, rising defaults could result in a run on banks (by depositors and investors in wealth-management products) and a possible credit crunch. This is a risk not only to the banks but to the Chinese financial system. Over the past week, Chinese banks' share prices have been under significant pressure because of a sudden rate spike in the Chinese interbank funding market amid slowing foreign-capital inflows and the banks' needs to fulfill investor obligations.

Not surprisingly, we continue to be concerned about the exposures of this fund and the impact that may have on performance. Instead of DEM, we prefer  WisdomTree Emerging Markets Small Cap Dividend (DGS). Even though this is a small-cap fund, over the past five years it was less volatile than the MSCI EM Index, and over the past year it was even less volatile than its large-cap sibling DEM. DGS' country allocations do not change much from year to year, and because it is a small-cap fund, it has little, if any, exposure to state-owned firms. It also has no exposure to Russian firms.

Please see the Portfolio Construction section in the (DEM) Analyst Report for more details on the fund and its index methodology.

   

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