Experiences May Vary for Emerging-Markets Investors

Over the last several years the story on emerging markets was well told and well bought. With stunning economic growth potential (compared with ailing developed-market countries) and generally strong sovereign balance sheets, the conditions certainly looked ripe for emerging markets to drive global growth and investment returns.

Investors responded with their wallets: Over the last year through July 31, they poured $42 billion into diversified emerging-markets funds, the fourth most popular category during that time period. 

But many of those EM investors can't be pleased with their returns so far, as emerging markets broadly have lagged, and not just a little bit.  iShares MSCI Emerging Markets ETF (EEM) has posted anemic three-year and five-year annualized returns of 0.9% and 4.3%, respectively, through Sept. 12, 2013. Meanwhile, the slow-growth U.S. has trounced broad emerging-markets funds, with the  SPDR S&P 500 ETF (SPY) gaining 17.3% and 8.3% over the same time periods.

So what happened? Part of the story is understanding that economic growth and market returns don't move in lockstep. Despite economic growth in the mid- to high-single digits, China's market performance has been very weak over the last few years, while the opposite has occurred in the U.S.

Emerging-markets investors might also be surprised to find they're not investing in what they think they are. For instance, instead of owning a fund primarily driven by a growing emerging-markets consumer sector, investors may see their EM fund buffeted by global commodities prices. (Basic materials make up 9% of EEM versus only 3% of SPY, and have been the worst sector performer over the last three and five years.)

As with any investment, emerging-markets fundholders need to carefully consider what they really want exposure to, and what they really own, to make sure they are getting what they bargained for.

Broad Emerging-Markets Funds
Out of a total of 179 U.S.-domiciled diversified emerging-markets funds in Morningstar's database, more than half are benchmarked to the MSCI Emerging Markets Index for exposure to these regions. This index is down over 6% year to date, and up only a marginal 1.2% over the last one year through Sept. 12. In 2012, the index rallied 18.2%, but it fell 18.4% in 2011.

Certainly, emerging-markets funds are a varied lot, and active fund managers may deviate far from their benchmark (be it the MSCI EM Index or other), but it still can be instructive to inspect the makeup of the MSCI EM Index to understand the recent performance trends of the broad benchmark itself.

According to its website, MSCI's EM Index covers over 800 securities across 21 markets, representing about 13% of the world's market capitalization, as of July 31. However, country-wise, China ranks first with a weighting of 18.76%, followed by South Korea, Taiwan, Brazil, and South Africa. These five countries account for 63.8% of the index's total exposure to the emerging-markets region, while the remaining 16 countries account for 36.2%.

Sector-wise the index is weighted heavily in financials (27.37%), followed by IT (14.51%), and energy (11.68%), meaning just these three sectors account for 53.56%, or a little more than half the total weight.

The exposures have been a drag on the index in recent times. Emerging-market financials were down almost 13% this year while IT was up less than a percent. The energy sector dropped about 15%. Over the last one-year period, too, the sector is down about 10%.

It's not surprising, therefore, to see that among the funds that tracked the MSCI EM Index, the better performers were mostly those that deviated from the benchmark, either in terms of country or sector weights.

For example,  Aberdeen Emerging Markets Institutional (ABEMX) has a better track record, soundly beating the benchmark in both 2011 and 2012. The fund has little resemblance to the MSCI EM Index both in terms of its country or sector weights, Morningstar senior fund analyst Karin Anderson wrote in a recent Fund Analyst Report, and its 7% China stake is less than half the index's, while its 12+% India stake is twice the index weight.

Similarly, for  Oppenheimer Developing Markets (ODMAX), Anderson writes that the portfolio's country weights can vary widely from the benchmark and category norm, while its stake in consumer defensive stocks is also twice the size of the typical rival's and the index's. That fund has returned 10% in the last one year through Sept. 12, while the MSCI EM Index has gained just over 1%.

The takeaway: emerging markets are far from a homogenous region, and with many ways to play the space against the index, investors may see a wide range of performance among EM funds. Experiences will vary, so be sure to know what you own.

Local Exposure
Purer exposure to local demand and the consumption-led economic growth potential of the emerging markets may be attained by the relatively fewer number of funds that have the MSCI EM Small Cap Index and the MSCI Frontier Markets 100 Index as their benchmark. These funds have mostly performed much better since 2012, owing to the more balanced representation of local economic and sector characteristics in those indexes. However, it must be mentioned that the frontier and small-cap markets are also much riskier and more volatile, and wouldn't be considered core exposure for U.S. investors.

In contrast to the MSCI EM Index, the MSCI EM Small Cap Index includes both consumer discretionary stocks and consumer staples in its top 10 holdings, and while financials still have the highest overall weighting at 19.3%, consumer discretionary is second with a 17.8% weighting.

According to Morningstar senior fund analyst Patricia Oey, "Rising domestic consumption will likely be a strong driver of economic growth in the emerging markets in the medium term. However, a market capitalization-weighted fund may not be the best vehicle to access these growth trends."

She adds, "We have seen a greater dispersion in performance by individual countries (prior to the Fed's announcement in May regarding eventual tapering), and weaker performance by the bigger EM countries, so active managers, or other passive funds that underweight the weaker-performing larger countries, were likely able to outperform the MSCI EM Index."

But if one common theme rang true across the region, it was the local consumption story. In India, for instance, the best performer year-to-date through July 31 was New Frontiers KC India. The fund was overweight on consumer defensives and health care, and underweight on financial services compared with its benchmark, as well as its category average. One of the worst performers both year-to-date and over the last one year was Dreyfus India , which was underweight on consumer defensives, but overweight on industrials and financials. Another poor performer, Eaton Vance Greater India (ETGIX), was also slightly underweight on consumer defensives, and like Dreyfus, overweight on industrials and financials. To be fair, it has been a bad year for industrials and rate-sensitive stocks in India, although it must be said simultaneously that most of those problems were man-made, stemming from bad governance and corruption scandals in sectors such as mining and telecommunications.

The consumption story was also at play in China, where funds that focused on small caps outperformed the broader market. Two of the best performers--Oberweis China Opportunities (OBCHX) and Matthews China Small Companies (MCSMX)--had the MSCI China Small Growth Index as their benchmark. Oberweis was overweight on technology as well as in consumer defensives and health care, while Matthews Small China was overweight on health care and consumer cyclical stocks. In the last one year through Sept. 12, Oberweis beat every other China-focused fund, logging a whopping 53% gain, while it was also the top performer year to date, up 35%. However, it was in the basement during the market meltdown of 2011, which is one of the reasons why Oey feels emerging-markets small caps may be too volatile for skittish investors. "A geographically diversified emerging-markets small cap fund is OK," she says, but the problem is "there are very few offerings." However, among the available options, she recommends  WisdomTree Emerging Markets SmallCap Dividend (DGS).

In keeping with the consumption theme,  Wasatch Emerging Markets Small Cap (WAEMX), which is a Neutral-rated fund, also has much more exposure to the consumer-defensive sector than both its typical rival and the MSCI Emerging Markets Small Cap Index, and also relatively sizable stakes in a few smaller markets such as the Philippines and Turkey.

For investors, the experience over the last year highlights the need to be more aware of the kind of emerging-markets exposure they are getting from their chosen funds, and whether it aligns with their own goals and risk tolerance. Because the region is so diverse, the experience of one emerging-markets investor may be quite different than another.

The good news is, despite volatility in the region, individual investors seem to be holding tight in their emerging-markets mutual funds, while institutional investors have been redeeming their EM ETFs, as suggested by recent Morningstar fund flow data. If individuals are more willing to ride out the short-term bumps for the long-term rewards in emerging markets, they may just get the edge on the so-called "smart money."