Go Active or Passive in Emerging Markets?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The Chinese market has been in the headlines lately. Joining me to discuss the impact on emerging-markets index funds and exchange-traded funds is Patty Oey--she's a senior analyst with Morningstar.

Patty, thank you so much for being here.

Patricia Oey: Thanks, Christine.

Benz: There has been this constant barrage of news regarding China. For people who haven't been staying super plugged into the headlines, let's summarize some of the major drivers of the Chinese market over the past several months.

Oey: So, in June, the China onshore market saw a rally of about 150%. Since then, it's down about 25% to 30%. So, there has been a lot of volatility in the Chinese stock market.

Benz: So, that selling was driven by what?

Oey: People might say that what happened leading up to the rally was that MSCI was talking about adding these stocks that are traded in Shenzhen and Shanghai. They were thinking about adding these types of stocks to their indexes--

Benz: These are the A shares.

Oey: Yes, these are the A shares. If they were to do that, you'd see a lot of foreign fund flows into China. Ahead of that, a lot of the local retail investors were excited that this might help prop up the market, so they were trying to get in a little early. That kind of led to the rally. When MSCI in June announced that they were going to hold off because the markets weren't really ready yet, we started to see a big sell-off.

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Benz: And more recently, we've had Chinese policy makers deciding to devalue the yuan. Let's discuss that action.

Oey: So, the currency is only down about 3% over the last week. But they say that they are trying to allow market forces to determine the value of their currency versus other currencies. In the past, they sort of fixed the rate at where they wanted it to be, and they say now that they are trying to let market forces determine that--more so than before. It's not necessarily a full-on free-floating currency, but they are trying to let market forces have more weight in determining the value of their currency.

Benz: Let's discuss the impact of the Chinese market's volatility on U.S. investors.

Oey: If you look at emerging-markets funds--we can look at both index funds and actively managed funds--the returns, year to date, have not been very good, at negative 15% or negative 20%. While China tends to be a larger allocation in emerging-markets funds and we've seen a lot of volatility, the impact actually hasn't been that much, because a lot of emerging markets aren't doing very well. Maybe, on average, an index fund will have about a 25% weighting in China and an actively managed fund would have somewhere between 15% to 20%. So, it's less, but overall the funds have done pretty much the same.

Benz: Let's discuss the spillover effects of China for other markets; Brazil, for example, is way down, year to date. Things are maybe more interconnected than people might have thought at first.

Oey: So, China let their currency fall a little bit. I think one of the concerns for emerging markets, overall, is that you could see other countries seeing falling currencies as well, whether it's by their central banks' actions or just money coming out of their economies and their economies slowing down. So, overall, that will negatively impact emerging-markets funds. You see China lowering their currency; maybe other countries will lower their currencies, their economies may get weaker, and that may negatively impact the stock market. And then, as U.S.-based investors, we translate all of our returns back into U.S. dollars; so if their currency is falling, then it's going to negatively impact returns.

If you want to take a more global view, if we're seeing emerging-markets currencies weaken, it definitely impacts the larger multinational companies that many investors hold. So, companies in the tech area, especially something like Apple (AAPL) or Qualcomm (QCOM), and companies in the consumer sector like P&G (PG) and Nestle (NSRGY)--those have very large emerging-markets exposure. If the emerging-markets consumer is not consuming as much, it will impact those kinds of companies, which are large companies in many people's portfolios.

Benz: So, certainly a lot of indirect effects as well as direct effects.

Oey: Right.

Benz: You mentioned the MSCI's possible addition of the A shares, and then they decided to back away from that. But Vanguard is going ahead with the plan to incorporate A shares into its emerging-markets index fund and ETF. Let's talk about that. Is that a concern? I know it's something that you and the team have been watching really closely over the past few months.

Oey: Last month, Vanguard announced that their emerging-markets index fund--they have a couple of mutual fund share classes and then they have their ETF VWO--they are going to add these China A shares to their fund. It will be about 5% to 7% allocation, depending on where the markets are. That will give those funds a total China allocation of about 30%, which we think is kind of high. Generally speaking, for investors, I think maybe they are probably better served by investing in an emerging-markets fund that's more geographically diversified. And then, over the long term, the A-share allocation is quite small, but they plan to increase it as China continues to liberalize its capital markets and capital accounts.

So, that A-share allocation is probably going to rise. FTSE and MSCI estimate that if the whole market is in their indexes, China could account for 40% to 50% of their emerging-markets indexes. So, index funds that track those indexes would have a very large China allocation, and maybe that's a bit of a concern for me--and should be for investors as well.

Benz: Given all of those concerns, what's your recommendation to investors who are looking in emerging markets? They've sold off; arguably maybe they're cheap--maybe not. But if investors wanted to have some sort of dedicated emerging-markets play, where should they go?

Oey: Well, given that it's very likely that these indexes will include China A shares--and so, therefore, the index funds will also add these China A shares--it maybe is a better option to go with an active manager. They do try to follow the benchmark--but not exactly. We definitely recommend that if you're worried about a very large China allocation, look for fund managers that are pretty benchmark-agnostic. A lot of funds with positive Morningstar Analyst Ratings are pretty benchmark-agnostic, they are bottom-up, and they look for good opportunities. So, for emerging markets, I think those are probably the better options.

Benz: Patty, thank you so much for being here to share your insights today.

Oey: You're welcome. Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com. G