Investors have looked to emerging market exchange traded funds to access potential growth opportunities in a low return environment and diversify an investment portfolio.
On the recent webcast, Define Your Emerging Market Smart Beta Strategy, Mike LaBella, Portfolio Manager at QS Investors, pointed out that the developing economies are projected to expand 4.1% this year and 4.6% in 2017, whereas developed economies are expected to grow 1.9% in 2016 and 2.0% in 2017.
In a survey of advisors on the webcast, the majority of respondents see the emerging markets accounting for a much larger percentage of global gross domestic product. Moreover, most advisors point to China as the dominant force in major indices and believe the Asian market could make up a larger slice of emerging portfolios as major indices include China A-shares.
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However, LaBella warned that the growth story is not shared equally. For example, Peru has been the best performing emerging market year-to-date, surging 44.2%, while Brazil jumped 42.0%. Meanwhile, China dipped 4.9% and Greece fell 14.1% this year.
“Average spread between best and worst countries in emerging markets is 97%,” LaBella said. “Therefore it is important to invest across the broad opportunity set.”
Consequently, traditional capitalization-weighted indices may overexpose investors to emerging market risks. For instance, the MSCI Emerging Markets Index includes a 24% tilt toward China, and over half of its country weights are concentrated in China, Korea and Taiwan. Additionally, financials, technology, energy and materials sectors account for 62% of the index.
To diminish these contraction risks, LaBella advises investors to consider alternative indexing methodologies.
“An alternative, smarter allocation seeks to fully take advantage of opportunities within emerging markets and manage risks,” LaBella said.
For instance, the Legg Mason Emerging Markets Diversified Core ETF (NasdaqGM: EDBI) through a partnership with QS Investors 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.
[related_stories]The result is an emerging market ETF with a more balanced allocation across macro drivers. 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 makes up 15.9% of EDBI’s portfolio.
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The indexing methodology has proven effective this year, with EDBI up 5.5% year-to-date while the MSCI Emerging Markets Index gained 2.7%.
Potential investors should be aware that the fund is still relatively new and has accumulated $6.6 million in assets under management. Nevertheless, Brandon Clark, Director & Product Manager at Legg Mason Global Asset Management, reminded financial advisors that executing large trade orders in EDBI can still be done effectively.
“ETF liquidity is different than stock liquidity, so the traditional rules do not apply,” Clark said. “The underlying basket is always the base of an ETF’s liquidity. The average daily volume in lower volume ETFs is less informative of real liquidity.”
Clark explained that financial advisors can work large orders through a block desk. Traders would work directly with market makers who have various ways to source liquidity. Additionally, investors should consider using limit orders and marketable limit orders to better control trades.
Financial advisors who are interested in learning more about the emerging markets can watch the webcast here on demand.