As many reassess their portfolios in a post-Brexit world, investors may want to consider opportunities in the emerging markets and related exchange traded funds.
The emerging markets may continue to strengthen on a depressed U.S. dollar, overseas easy money policies and the ongoing search for value in an prolonged bull run.
For starters, the emerging markets are among the cheapest assets around after underperforming developed markets over the past couple of years. The widely monitored iShares MSCI Emerging Markets ETF (NYSEArca: EEM) shows a 12.09 price-to-earnings ratioi and a 1.28 price-to-book and the Vanguard FTSE Emerging Markets ETF (NYSEArca: VWO) has a 12.50 P/E and a 1.41 P/B, whereas the S&P 500 Index is trading at a more elevated 18.57 P/E and a 2.57 P/B.
The U.S. dollar recently weakened to its lowest level in almost a year in May and still lacks direction after falling off from the highs at the start of the year. A strong USD would weigh on emerging markets due to foreign exchange risks or a depressed U.S. dollar-denominated return when converting from emerging local currencies to USD. A weaker dollar also makes it easier for developing economies to service debt, which many governments have denominated in U.S. dollars. Moreover, a depreciating greenback has helped support prices for raw materials, such as oil and metals, which are among some large exports of many developing countries.
Similar to what happened in the U.S. when the Federal Reserve implemented loose monetary policies, international investors may also turn to emerging markets as a better source of yield after global central bankers expanded their easy money policies. With negative interest rates in areas like the Eurozone and Japan, investors would turn to riskier assets to generate more attractive returns, such as the high growth potential of the developing markets.[related_stories]
Nevertheless, potential investors should be aware that not all emerging markets are created equal. While ETF options like EEM and VWO track major emerging market indices, these ETFs follow market capitalization-weighted indices that could overexpose investors to a few large countries or a specific sector.
For instance, EEM includes a 25.4% tilt toward China, 14.4% to South Korea and 12.0% to Taiwan, along with a hefty 25.7% weight toward the financials sector. Meanwhile, VWO holds a large 28.4% China weight, 15.3% in Taiwan and 12.5% in India, along with 24.2% in financials.
Alternatively, as a way to diversify country and sector exposure, investors may consider smart-beta or alternative index-based ETFs that are less top heavy, compared to traditional beta-index ETFs. With the recent surge in smart-beta interest, ETF investors now have a number of new alternative emerging market options to choose from.
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. EDBI is less top heavy, with 13.8% China, 9.5% India and 9.0% Malaysia, among its top holdings. The financial sector also only makes up 15.8% of the portfolio.
The JPMorgan Diversified Return Emerging Markets Equity ETF (NYSEArca: JPEM) tracks the FTSE Emerging Diversified Factor Index, which incorporates a multi-factor screening process that combines value, momentum and quality factors. JPEM’s top country weights include China 18.5%, Taiwan 18.3% and India 8.2%.
The Deutsche X-trackers FTSE Emerging Comprehensive Factor ETF (NYSEArca: DEMG) tries to reflect the performance of the FTSE Emerging Comprehensive Factor Index, which targets emerging market equities based on five factors, including quality, value, momentum, low volatility and size. DEMG’s top countries include China 15.1%, South Africa 14.8% and Taiwan 12.7%.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.