While not in the forefront of investment locales, the emerging markets may show some hidden potential, and investors seeking exposure to the developing economies could utilize a smart-beta index-based exchange traded fund to generate enhanced returns.

On the recent webcast, What is Comfortable is Rarely Profitable:  Exploring the Principles of Contrarian Investing, Research Affiliates Chairman and CEO Rob Arnott argued that emerging market equities are a great contrarian opportunity today. Specifically, investors can utilize the PowerShares FTSE RAFI Emerging Markets Portfolio (NYSEArca: PXH) to gain exposure to the asset class.

Arnott points out that most popular plays in the marketplace make investors feel comfortable, but the securities have become expensive after the market run. Looking at the three-year cumulative return through the end of September 30, the MSCI Emerging Market Index rose 23.2% while the S&P 500 gained 86.1%.

“EM equities are lagging U.S. equities by more than 60% cumulatively as investors seek the perception of safety,” Arnott said.

Moreover, forward price-to-earnings reveal that U.S. stocks are more expensive than the developing markets. Consequently, Arnott contends that U.S. equity valuations do not support sustained outperformence, even if the economy continues to expand.

Additionally, the RAFI emerging market strategy shows even cheaper valuations. For example, PXH shows a price-to-earnings ratio of 9.2 and a price-to-book of 1.3. In contrast, the MSCI Emerging Markets Index has a 12.5 P/E and a 1.5 P/B while the S&P 500 index has a 17.6 P/E and a 2.5 P/B.

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