Look Under the Hood When Adding EM ETFs to a Portfolio

These traditional market-cap weighted indices expose investors to significant risks, especially after the recent run up in technology stocks, which may leave investors exposed to some of the more pricey segments of the emerging market.

“In our view, this over-concentration not only leaves investors reliant on a handful of return drivers but diminishes the portfolio diversification benefits an emerging markets allocation looks to provide versus developed markets. Compared to lower-weighted countries in the index, China, Taiwan and South Korea, realize the highest correlation to developed markets such as the US,” LaBella said.

Alternatively, investors seeking emerging market exposure may consider a smart beta play that follows an alternative index weighting methodology. 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.

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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 result is an emerging market ETF with a more balanced allocation across macro drivers. Specifically, among its top country and sector weights.

For information on the developing economies, visit our emerging markets category.