Skip to Content
ETFs

Cheap Exposure to Attractively Valued Emerging-Markets Stocks

Emerging-markets stocks are trading at lower valuations than U.S. stocks, despite their higher expected growth rates. This ETF offers a good way to own them.

The fund owns nearly 1,800 emerging-markets stocks of all sizes, covering 99% of the investable universe, and weights them by market capitalization. These holdings span 24 markets, including Taiwan and South Korea. Similar to its market-cap-weighted peers, China represents the fund's largest country weighting, at about 30% of the portfolio. This gives it significant exposure to the Chinese yuan, as well as local risks specific to the Chinese market. Investors may not be compensated for this risk, making such a large single-country allocation less than ideal.

Market-cap-weighting pulls the portfolio toward the largest emerging-markets stocks, many of which have global operations. These include Samsung Electronics and Taiwan Semiconductor. The inclusion of small-cap stocks improves diversification, although they only account for a small portion of the portfolio. These firms tend to be more highly leveraged to their local markets than their larger counterparts.

From its inception in October 2012 through October 2017, the fund outpaced the diversified emerging-markets Morningstar Category average by 55 basis points annualized, with comparable volatility. This is a very risky category that has consistently exhibited much higher volatility and downside risk than foreign developed-markets stocks. Unlike some of its active peers, this fund does not take any steps to mitigate the impact of market downturns. However, its smaller-than-average cash drag and cost advantage should give the fund an edge over the long run. Like most of its peers, the fund does not hedge its currency risk. Since inception, currency fluctuations accounted for nearly one third of the fund's total volatility.

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. Most importantly, this is because consensus growth expectations are already reflected in market prices. For strong growth to translate into strong stock returns, it must exceed those already high expectations. This is why growth stocks haven't beaten their slower-growing value counterparts over the long term. 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. Finally, many of the larger firms listed in emerging markets generate a significant portion of their earnings abroad. This means that their profits can grow at a different rate than the domestic economy.

The best reason to own emerging-markets stocks is for the diversification they provide. However, they may also offer higher expected returns than developed-markets stocks when they are trading at lower valuations, as they are now. Over the trailing 10 years through October 2017, the MSCI Emerging Markets and MSCI USA Investable Market Indexes were only 0.81 correlated. During that time, the MSCI Emerging Markets IMI lagged the U.S. index by 6.6 percentage points. As a result, its holdings are trading at lower valuations. At the end of October 2017, the emerging-markets index's holdings were trading at 13.5 times forward earnings, on average, while the corresponding figure for the MSCI USA IMI was 21.3.

Although the emerging-markets stocks in this portfolio have higher expected growth rates than their U.S. counterparts, there are good reasons for this valuation gap. Emerging-markets stocks are considerably riskier than U.S. and other developed-markets stocks. They are often priced in more-volatile currencies, exposed to greater political risks, and trade in markets with less transparency and fewer investor protections. However, because their returns aren't perfectly correlated with developed-markets stocks, the small allocation to emerging-markets stocks shouldn't have a big impact on overall portfolio volatility.

The fund tilts toward the largest emerging-markets stocks, which tend to be more profitable than their smaller counterparts. However, some of the fund's largest holdings are state-owned enterprises, which may prioritize political objectives over profit maximization. However, the fund has limited exposure to individual names. Its top 10 holdings only account for about 22% of the portfolio. Similar to the category average, financial services and technology represent the fund's largest sector weightings, each accounting for over a fifth of the portfolio.

This portfolio accurately reflects emerging-markets investors' opportunity set. While emerging stock markets are arguably less efficient than developed markets, active managers in emerging markets have still had a hard time outpacing their index counterparts. According to Morningstar's Active/Passive Barometer, only 33.7% of active managers in the diversified emerging-markets category survived and outpaced the average index fund in the group over the trailing 10 years through June 2017.

Portfolio Construction The fund employs a sampling approach to track the market-cap-weighted MSCI Emerging Markets Investable Market Index. The resulting portfolio accurately reflects the composition of the market, diversifies company-specific risk, and promotes low turnover. But it does have considerable exposure to China, limiting the Process Pillar rating to Neutral. MSCI starts with all publicly available stocks listed in 24 emerging-markets countries. The index then sorts them on free-float-adjusted market capitalization and targets those representing the largest 99% of the investable universe by market capitalization. The index applies additional screens for liquidity and foreign ownership eligibility to make it easier to track. The managers fully replicate the index among the larger-cap names and take a representative sample of the smaller index constituents, which helps mitigate transaction costs. The index is refreshed semiannually in May and November.

Fees BlackRock charges a low 0.14% expense ratio for this offering, making it one of the cheapest options in the category. Therefore, it earns a Positive Price Pillar rating. Over the trailing three years through October 2017, the fund beat its benchmark by 1 basis point annually. This was partially due to securities-lending revenue, which helped offset the fund's expenses.

Alternatives

Bronze-rated

More-risk-averse investors might consider Silver-rated

Xtrackers MSCI Emerging Markets Hedged Equity DBEM (0.65% expense ratio) and iShares Currency Hedged MSCI Emerging Markets HEEM (0.71% expense ratio) both offer currency-hedged portfolios, which should help reduce volatility. However, it can be expensive to hedge emerging-markets currencies.

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

More on this Topic

Sponsor Center