Developed markets have led the charge, with the U.S. experiencing multi-year rally, but now, investors may be turning to developing economies and emerging market-related exchange traded funds in search of untapped opportunities.
We are beginning to see a shift to emerging market assets. After an encouraging first quarter, emerging market equities experienced inflows for the first time in five years, according to a Legg Mason note.
On Wednesday, the emerging markets rose the most in six weeks and hit a one-week high. The improved confidence in financial markets has outweighed anxiety over the Federal Reserve’s hawkish stance on interest rates, with a potential hike next month, Bloomberg reports.
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“Economic development over the last two decades has made emerging markets significant drivers of global growth,” Michael LaBella, portfolio manager at QS Investors and manager of the Legg Mason Emerging Markets Diversified Core ETF (EDBI), said in the note. “Ten years ago EMs represented 25 percent of global gross domestic product – but they now account for nearly 40%. With annual growth rates double those of the U.S., emerging markets’ share of global gross domestic product has the potential to grow. That can create opportunities.”
However, the positive momentum is not shared equally with the broad emerging market group. Developing economies are a heterogeneous with significantly variant economic, political and developmental differences.
[related_stories]For instance, among the top performers this year, Peru and Brazil have returned almost 40%, whereas Chinese equities dipped 9% and Greece fell 5%.
“While a 50% spread between the best and worst performing countries may seem high, it is actually quite normal in EM,” LaBella said, pointing out that there was an even wider spread of 108 percentage points between the best and worst performing emerging markets last year.
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Consequently, investors should be aware of the potential opportunities and risks that the divergence reflects in the emerging markets.
“The clear danger is the increased macro and country-specific risks that come with emerging markets,” LaBella added. “This can be of particular concern for investors who may attempt to pick individual country positions, getting overly excited about a small number of prospects, without taking into account the predictability of macroeconomic events.”
Looking at some of the most popular emerging market funds, many track widely observed market capitalization-weighted benchmarks like the MSCI Emerging Markets Index. However, LaBella warned that these benchmarks are highly concentrated to some single countries – the MSCI benchmark includes over 50% exposure to just China, South Korea and Taiwan, and the FTSE Emerging Market Index may raise its China exposure to 50% over time.
Consequently, investors may consider alternative index-based emerging market ETFs that focus on quality and diminish exposure to riskier areas as a way to diversify across developing countries and generate improved risk-adjusted returns over the long haul.
For example, the Legg Mason Emerging Markets Diversified Core ETF (NasdaqGM: EDBI) breaks down the universe of securities into investment categories based on sectors and countries. The five-year return patterns of the countries and sectors are taken to uncover relationships – areas that behave alike or differently. The underlying index then combines investment categories with more highly correlated historical performance into smaller number of so-called clusters, which are categorized based on tendency to behave similarly, or show various correlations. Each of these clusters are then equally weighted individually and also equally weighted across the portfolio to produce a diversified investment strategy.
The end result is an emerging market ETF with a broader sector and country exposure. Specifically, among its top country weights, EDBI only includes a 13.4% tilt toward China, followed by Malaysia 9.3%, India 8.9%, Turkey 7.8% and South Africa 7.1%. Additionally, while financials are still a major component, the financials sector only make sup 15.9% of EDBI’s portfolio.