Finding Value in the Emerging Markets Equity Exodus

Emerging market equity ETFs posted another selloff for the month of January, totaling $10 billion in outflows globally – the largest monthly outflows for this segment on record. In fact, last week marked the 6th week of steady outflows, and set a record as the largest weekly outflow since August 2010. Investors seeking to avoid exposure to country specific turmoil, weak Chinese manufacturing data, plus interest rate adjustments in emerging market countries like Turkey, drove the selloff.

Despite strong negative sentiment and ongoing scrutiny of the Fed’s potential next steps, emerging market equity valuations are attractive and the asset class remains a vital part of a well-diversified portfolio (emerging markets currently account for 11% of the world’s market capitalization). As my colleague Russ Koesterich recently pointed out, emerging market equities are generally growing at a faster rate than developed markets and now look cheap by most metrics. Currently emerging market equities are trading at about a 40% discount to developed country stocks, representing the largest discount since the financial crisis. There is significant value here if you know where to look.

The Emerging Market Equity ETF Landscape

It’s important to consider the bigger picture when contemplating the significance of these outflows. We believe we are far from an emerging markets equities crisis, as we are down only 8% this year. Emerging market ETFs represent about $229 billion of the $4.5 trillion total investable emerging market equity universe. That’s about 5%, and is also less than a quarter of the assets held by active emerging market funds.  Additionally, the $35 billion drop in emerging market ETF assets since the end of May 2013 represents less than 0.8% of the underlying market.

While emerging market ETFs as a category have experienced outflows recently, this has not been the case for all funds. In fact, the majority of outflows have occurred in the two largest emerging market equities funds (Vanguard’s FTSE Emerging Markets ETF (VWO) and the iShares MSCI Emerging Markets ETF (EEM)). Many others, including the iShares Core MSCI Emerging Markets ETF (IEMG) and the iShares MSCI Brazil capped ETF (EWZ), actually saw significant inflows in January despite a challenging macro environment.

It’s also important to note that ETFs aren’t the only investment vehicles experiencing outflows for emerging market exposures. Mutual funds have had outflows of $34.2 billion since the start of June 2013 through last month, while ETFs outflows totaled $16.4 billion during the same period.  For the month of January, mutual fund outflows totaled $3.4 billion while, as previously mentioned, ETF outflows totaled $10 billion.

What this Means for Investors

We know that emerging markets tend to be volatile, and we expect them to remain so in the near term. As my colleague Russ Koesterich notes in a recent post, not all emerging markets are created equal. Bright spots, such as South Korea, have strong economic fundamentals. What’s more, emerging markets can provide significant returns over time when implementing the appropriate strategy. Investors can increase their emerging market equity exposure through liquid and transparent ETFs at the regional, sub-regional, or individual country level.  It pays to look under the hood of your emerging market equity investments as we explored in Emerging Equity Exposed last year.

Longer term, we believe growth prospects for emerging markets remain attractive relative to the developed world. I recently explored Three Ways to Invest in Emerging Markets, focusing on why contrarian investors may want to consider this sector. Here are three ways to add emerging markets to your long-term investment strategy: