Investors are beginning to adopt greater international exposure to diversify their investment portfolios, and more are picking up smart-beta exchange traded funds to potentially enhance the overseas returns. However, potential investors should understand how these alternative index-based strategies may differ from traditional market cap-weighted indices.
“As investors increasingly consider fundamentally weighted ‘smart-beta’ ETFs, we think they need to understand and monitor how the exposure these offerings provide can and does change,” Todd Rosenbluth, S&P Capital IQ Director of ETF Research, said in a research note.
For instance, the WisdomTree Emerging Markets Equity Income Fund (NYSEArca: DEM), which has $1.47 billion in assets, reviews components on an annual basis. Christopher Gannatti, WisdomTree Associated Director of Research, explained that DEM’s dividend growth strategy tracks companies with positive fundamentals and annually re-weights the index to reflect the most recent corporate decisions. Organic growth, new entrants and currencies are three factors that the underlying index will also consider when rebalancing components.
The income-oriented emerging market index will focus on cash dividends paid, and companies with greater dividends are given a larger weight in the index. For instance, Chunghwa Telecom was added as part of the late October 2015 rebalance after the Taiwan-based telecom provider doubled its dividend in July 2015.
Investors should consider individual indexer quirks. For instance, WisdomTree expanded the country classification for China to include companies that are domiciled in China but may be incorporated somewhere else. For example, CNOOC, an oil & gas exploration & production company domiciled in China but incorporated in Hong Kong, which is considered a developed market, was added into DEM during the October rebalance.
Moreover, Gannatti pointed to currency considerations, notably the impact of currencies in the emerging markets on dividends. For example, the Mexican peso and Turkish lira have depreciated against the U.S. dollar, which has diminished the impact of dividend growth in the markets in U.S. dollar terms.
Due to the recent dividend shifts and country reclassification, DEM’s country exposure has shifted. Taiwan’s DEM weight increased 910 basis points at the end of October as dividend growth in Taiwanese companies jumped 17% over the past 12-month period, even after adjusting for the weaker currency. On the other hand, Russia’s weight fell 660 basis points due to the sharp depreciation in the ruble currency.