A Costly Choice for Investing in Emerging-Markets Stocks

Similar to its market-cap-weighted peers, this exchange-traded fund has significant exposure to individual country risk. Despite the inclusion of 23 emerging markets, China (26%), South Korea (15%), and Taiwan (13%) jointly account for over half of the portfolio because of their large relative size. The same three countries make up less than 40% of the typical actively managed fund in the category. MSCI, the firm behind the fund's index, is also considering adding China A-shares, which would further increase the fund's allocation to Chinese stocks.

This broad portfolio effectively diversifies company-specific risk, but it has a larger-cap orientation than its typical peer. The top 10 holdings account for just over 20% of the portfolio, compared with 30% for the average fund in the category. These include Samsung Electronics,

Over the trailing 10-year period through August 2016, the fund trailed the category average by 20 basis points annualized. Despite its cost advantage, this fund will likely underperform the category average during periods of weak emerging-markets performance because it is always fully invested, unlike active managers who can increase cash allocations during unfavorable market conditions.

Fundamental View Strong economic growth forecasts are often cited as a rationale for investing in emerging markets, but such growth has not translated into superior stock performance historically for several reasons. First, many of the larger firms listed in emerging markets generate a significant portion of their revenue and income abroad. This means that their profits can grow at a different rate than the domestic economy. Second, publicly traded companies often grow at a slower rate than their local economies because privately held companies drive a lot of that growth. Additionally, poor corporate governance in some emerging markets can lead to dilution of corporate earnings through new stock issuance.

Valuations also matter. From 2001-10, emerging markets handily outperformed developed markets. At the beginning of this period, emerging-markets valuations were below their historical average following several financial and political crises, while the valuations in the U.S. stock market were high following the historic 1990s bull market. Recently, emerging-markets valuations have declined relative to developed markets'. Over the trailing 10-year period through August 2016, the average difference in trailing 12-month P/E ratios for the MSCI World Index relative to the MSCI Emerging Markets Index was 2.7, showing emerging markets tend to trade at a lower valuation than developed markets. At the end of August 2016, the difference was 5.0, indicating emerging-markets valuations relative to developed markets are currently lower than their trailing 10-year average.

This fund offers a good way to get exposure to emerging-markets stocks. Its market-capitalization-weighting approach promotes low turnover and skews the portfolio toward large multinational firms. These companies tend to be more profitable and less volatile than their smaller counterparts. However, some of the fund's largest holdings are state-owned enterprises, which may be forced to prioritize political objectives over profit maximization. The fund's sector weightings are similar to the category average, but the fund has greater exposure to technology and less exposure to consumer defensive companies. Financial services and technology are the two largest sectors; each represents just over one fifth of the portfolio.

Emerging-markets stocks consistently exhibit higher volatility than stocks listed in developed markets. For example, over the trailing 10-year period through August 2016, the MSCI Emerging Markets Index's volatility was roughly 20% and 35% greater than the MSCI EAFE (foreign developed markets) and S&P 500, respectively.

Despite this risk, emerging-markets stocks can provide significant diversification benefits. Over the trailing 10-year period through August 2016, the MSCI Emerging Markets Index and S&P 500 were only 0.79 correlated. Over the same period, the correlation between the MSCI Emerging Markets Index and MSCI EAFE Index, which tracks stocks listed in foreign developed markets, was 0.88.

Portfolio Construction This fund uses near full replication to track the market-cap-weighted MSCI Emerging Markets Index. This approach results in a portfolio that reflects the composition of the market, diversifies company-specific risk, and promotes low turnover. MSCI starts with all publicly available stocks listed in 23 emerging-markets countries. These stocks constitute the investable market universe. The index then sorts them on free-float-adjusted market capitalization and targets those representing the largest 85% of the investable universe by market capitalization, thereby eliminating small-cap stocks. The index applies additional screens for liquidity and foreign ownership eligibility to make it easier to track. This resulting index portfolio includes over 800 constituents. The fund's advisor then fully replicates the index to mimic its investment profile.

Fees The fund charges an annual fee of 0.69%, which is cheap relative to the category average of 1.46%, but there are even better diversified index alternatives for less than one third of the price. Over the trailing three years through August 2016, the fund has trailed its benchmark by 66 basis points annualized. This is partially due to securities-lending revenue, which helped offset the fund's expenses.

Alternatives Schwab Emerging Markets Equity ETF SCHE offers a similar market-cap-weighted exposure to large- and mid-cap stocks listed in emerging markets. It is the cheapest ETF in the category with a 0.13% expense ratio.

Vanguard FTSE Emerging Markets ETF VWO (0.15% expense ratio) recently transitioned to a new FTSE index that includes China A-shares and small-cap stocks. VWO is also available in a mutual fund format,

More-risk-averse investors might consider

Deutsche X-trackers MSCI Emerging Markets Hedged Equity DBEM (0.65% expense ratio) and iShares Currency Hedged MSCI Emerging Markets HEEM (0.73% expense ratio) both offer currency-hedged portfolios to protect against the volatility of emerging-markets currencies.

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