Why Emerging Market Indexes?
Mutual fund managers, like all investors, are susceptible to behavioral biases that can negatively affect their investment decisions. This is exhibited through the table above, which shows that the majority of active managers in the Morningstar Diversified Emerging Markets category actually underperformed MSCI EM over the most recent 10-year period and during seven of the last 10 calendar years.
For believers of active management, I think these results are even more alarming given the fact that MSCI EM is a market cap-weighted index. Market cap-weighted indexes typically give the greatest weight to the stocks with the highest prices, without regard to any measure of fundamental value. As a result, market capitalization-weighted indexes tend to over-weight more expensive equities, sectors and countries, and under-weight those that may be relatively less expensive.
Why Smart Beta?
I believe it is especially important now to have a disciplined focus on the valuation opportunities present in the emerging markets, specifically cash flow and dividends. WisdomTree Indexes use a rules-based methodology to weight companies by their underlying fundamentals, such as dividends or earnings, because we believe that stock markets are not always efficient. Furthermore, WisdomTree rebalances its Indexes annually to adjust for relative value.
While stock prices may deviate from the underlying fundamental value for a number of reasons, one is sentiment, which can result in “herding” behavior. Currently, I feel this is one reason for emerging markets’ recent underperformance, but I am confident the market will eventually revert back to its underlying fundamentals. As a result, investors shouldn’t abandon the space, but instead have a rules-based strategy that focuses on fundamentals and is not susceptible to psychological biases.
1The U.S. OE Diversified Emerging Markets category encompasses all the open-ended mutual funds and ETFs that Morningstar categorizes as “Diversified Emerging Markets” funds.
2Sources: Zephyr StyleADVISOR, Morningstar; Index inception: 06/01/2007.
3Sources: Zephyr StyleADVISOR, Morningstar; Index inception: 08/01/2007.
Important Risks Related to this Article
There are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Funds focusing on a single sector and/or smaller companies generally experience greater price volatility. Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation, intervention and political developments. Due to the investment strategy of the Funds, they may make higher capital gain distributions than other ETFs. Please read each Fund’s prospectus for specific details regarding the Fund’s risk profile.
Investments focused in China are increasing the impact of events and developments associated with the region, which can adversely affect performance. Investments focused in Japan are increasing the impact of events and developments associated with the region, which can adversely affect performance. Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments.