So far this year, emerging market equities have been on a rampage, almost trading in a straight line higher. While this asset class can be worrisome to traditionally home-country centric US investors due to a variety of factors, the innovation in ETFs can potentially allow for some of these worries to be mitigated by slicing and dicing and repackaging the exposures.
Despite the variety of options available in the EM equity space, the majority of assets continue to reside in the standard broad market based ETFs, with nearly 85% of the assets being held by the top three ETFs. But even within these more vanilla offerings there can be a decent amount of dispersion based on the underlying index.
Among the top EM equity ETFs there are three different index providers: FTSE, MSCI, and S&P. One of the major points of dispersion amongst these providers is the classification of South Korea as an emerging market country in their ‘base’ classification:
- MSCI: Included
- FTSE: Excluded (classified as Developed)
- S&P: Excluded (classified as Developed)
While it seems more widely accepted that South Korea has reached a developed country status, you can see MSCI has continued to classify the country as emerging. Given its relative size in that universe, this can account for nearly a 15% difference in exposure between MSCI and FTSE/S&P. And given that two behemoths in the ETF space use that index provider (EEM and IEMG), it can be a source of decent relative performance dispersion. While there are other factors at play I will touch on shortly, here is the performance.
There are a couple other differences within the subsets of the index providers mentioned. From the table above, VWO includes China A-shares while SCHE does not (nor does either of the MSCI nor the S&P ETFs).
Another difference is that some of these ETFs follow indices which include small cap issues (IEMG/SPEM/VWO) whiles others do not (EEM/SCHE). Here is a table of market cap exposure (as classified by Bloomberg), which shows the difference in the smallcap exposure:
But what about investors looking to branch out from these more traditional ETFs? There are a few different routes an investor could go down for alternatives:
Multi-Factor
It would seem the next logical step could be to look at the ever-growing number of multifactor ETFs available in the space. Just as in their US and developed markets counterparts, these ETFs look to take advantage of differing factor effects to generate positive alpha over that of a traditionally weighted ETF. While the assets in these funds are still small relative to the big players, there are a couple which have garnered decent assets in a short amount of time, with an example being GEM (Goldman Sachs ActiveBeta EM), which has accumulated $1.65B since its inception just over two years ago.
Single-Factor
For those investors who prefer to take the single-factor vs multi-factor route, there are multiple choices available in the EM realm. A couple of the more popular factors being utilized (based on number of ETFs and AUM) are Dividend and Low Volatility. One concern for some investors regarding investing in emerging markets is the increased volatility of the asset class. And while they go about it in different ways, both factors tackle that concern. Regarding dividends, the added yield over a traditionally-weighted ETF can (but will not necessarily always) act as a buffer against price volatility. Additionally, emerging market companies who have the capability of paying dividends are most likely more well-established companies and could benefit to a flight-to-quality shift especially in times of market turmoil. And low volatility ETFs obviously look to tackle the volatility problem, although once again depending on market conditions these ETFs could end up flipping to high volatility.
Currency-Hedged
An additional source of volatility when investing outside the US, whether developed or emerging, is the currency effect. These currency-hedged vehicles look to take out that effect and given investors a purer local-market return (less any hedging costs). Currency hedging is available in traditionally weighted and single/multi-factor varieties. While in this current environment of a weakening dollar, currency-hedging has been a bit of a drag on performance and as such these ETFs are a bit out-of-favor. But if the dollar were to strengthen or at a minimum become more rangebound, these ETFs could come back on the radar.
Exclusionary/Other
Exclusionary may not be quite the right term here, but this is a bit more of an ‘other’ type category. There are a few different iterations, but these ETFs look to exclude certain exposures as part of the strategy. This may include:
- ESG ETFs – which exclude companies in ‘harmful’ industries such as tobacco. ESG could somewhat be considered a factor as well
- Ex-China – based on volatility and a lack of transparency/governance, there are a few broad-based ETFs which exclude Chinese exposure.
- BRIC/BICK – While not exclusionary per se, these ETFs only include exposure from the largest EM economies in Brazil, India, China, and Russia/Korea. Investors feel these economies are the driving force behind EM as a whole and that the other countries just present noise and/or do not add significant investment value.
While US-centric investors have historically had minimal to no exposure to emerging markets, they seem to be a growing part of a more holistic allocation. And while there can be tradeoffs between the added volatility and potential diversification benefits, the various flavors of emerging market equity exposure in ETF land can help calm some of the worries investors may have if/when moving into the space.
Clayton Fresk is a Portfolio Manager at Stadion Money Management, a participant in the ETF Strategist Channel.
Disclosure Information
Past performance is no guarantee of future results. Investments are subject to risk and any investment strategy may lose money. The investment strategies presented are not appropriate for every investor and financial advisors should review the terms and conditions and risks involved. Some information contained herein was prepared by or obtained from sources that Stadion believes to be reliable. There is no assurance that any of the target prices or other forward-looking statements mentioned will be attained. Any market prices are only indications of market values and are subject to change. Any references to specific securities or market indexes are for informational purposes only. They are not intended as specific investment advice and should not be relied on for making investment decisions. At the time of writing, Stadion held long positions in EEM, IEMG, and VWO in certain of its strategies. The S&P 500 Index is the Standard & Poor’s Composite Index of 500 stocks and is a widely recognized, unmanaged index of common stock prices. One cannot invest directly in indexes, which are unmanaged and do not incur fees or charges. Founded in 1993, Stadion Money Management is a privately owned money management firm based near Athens, Georgia. Via its unique approach and suite of nontraditional strategies with a defensive bias, Stadion seeks to help investors—through advisors or retirement plans—protect and grow their “serious money.” Contact Stadion at 800-222-7636 or www.stadionmoney.com. SMM-102017-1006