The Vanguard FTSE Emerging Markets ETF (NYSEArca: VWO) and the iShares MSCI Emerging Markets ETF (NYSEArca: EEM), the two largest emerging markets ETFs by assets, are down an average of 7.1% this year.
In another sign that intelligent indexing can work for ETF investors, those developing markets funds that subscribe to a factor-based weighting methodology have been less bad than their cap-weighted peers this year. [Low Volatility ETFs for Emerging Markets]
While cap-weighted emerging markets ETFs are large, liquid and highly popular with investors, there are drawbacks with these ETFs as well. “Most long-term investors who have an interest in emerging markets know that these ETFs are not the best funds to capitalize on the long-term growth opportunity in emerging markets, due to their market-cap-weighting approach,” says Morningstar analyst Patricia Oey.
As Oey notes and has been frequently highlighted in the past, cap-weighted emerging markets ETFs have come under criticism for, among other “offenses,” being too heavily allocated to Brazil and China, excessive weights to state-run firms and not enough exposure to the consumer story. [A Case for the Emerging Markets Consumer]
Factor-based ETFs can help investors avoid some of the drawbacks of cap-weighted emerging markets funds. Investors may already be familiar with some of the options, including the WisdomTree Emerging Markets SmallCap Dividend Fund (NYSEArca: DGS).
Although small-caps are seen as more volatile than their larger peers “DGS’ volatility has been lower than that of the large-cap benchmark MSCI Emerging Markets Index over the past five years. This is because DGS has somewhat of a quality tilt thanks to its dividends-paid weighting methodology,” according to Morningstar.
DGS, like many of the other WisdomTree dividend ETFs, weighs constituents companies based on annual cash dividends paid. The $1.7 billion ETF has a distribution yield of 4%. Taiwan dominates the ETF at 27.3% of its weight while South Korea, Malaysia and South Africa all receive weights of more than 9%.
The iShares MSCI Emerging Markets Minimum Volatility ETF (NYSEArca: EEMV) has also been a hit with investors. EEMV has captured $2.5 billion in assets in just 26 months on the market. Over 47% of EEMV’s country weight is allocated to China, Taiwan and South Korea. The fund is down 3.9% this year, which is still better than EEM and VWO.
Low volatility “strategies can have high turnover and can include securities that are not that liquid. With higher transaction expenses in emerging markets, a low-volatility index without appropriate liquidity and investability screens could be very costly to replicate and drag on the performance of the fund relative to its index,” according to Oey.
EEMV has a legitimate rival in the form of the PowerShares S&P Emerging Markets Low Volatility Portfolio (NYSEArca: EELV). Investors have started to take note of EELV this year as the fund has pulled in $140.5 million of its $221.5 million in assets since the start of 2013.
Over 51% of EELV’s country weight goes to Taiwan, Malaysia, and South Korea. EELV has also outperformed VWO and EEM this year.
WisdomTree Emerging Markets SmallCap Dividend Fund
Tom Lydon’s clients own shares of EEM.