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.
While the emerging markets may be riskier and more volatile than other assets, investors can potentially generate greater returns. Arnott has already put his money where his mouth is, exiting all his personal U.S. allocations, except a couple of long/short strategies.
“Emerging market have shifted from interesting to really compelling,” Arnott added.
Invesco PowerShares Vice President of ETF Product Management John Feyerer also pointed out that the PowerShares FTSE RAFI US 1000 Portfolio (NYSEArca: PRF) is among the first ETFs to track a smart-beta fundamentally weighted index that single out market factors like book value, cash flow, sales and dividends in determining component weights. PRF was launched in 2005.
PRF also tries to focus on value plays and underweight expensive securities. For instance, Arnott points out that the popular Priceline (NYSE: PCLN) play makes up a 0.3% weight in the Russell 1000 index, whereas PCLN is only 0.04% of the FTSE RAFI US 1000.
Financial advisors who are interested in learning more about contrarian investing with fundamentally-weighted ETFs can listen to the for webcast here.