Investors who are looking into emerging-market stocks may consider the merits of a multifactor, smart beta ETF approach to access this market segment and diminish potential downside risks.
On the recent webcast (available On Demand for CE Credit), Emerging Markets: When the time is right, will you be ready?, Matthew Miskin, Market Strategist at John Hancock Investments, explained the long-term benefits of emerging market exposure. The developing economies may appear riskier as opposed to its more stable and developed counterparts, but the benchmark MSCI Emerging Market Index has exhibited a better risk-adjusted return over the long term.
Since the end of 2000, the MSCI Emerging Market Index showed a Sharpe ratio of 0.36, compared to the lower 0.33 Sharpe ratio for the MSCI USA Index, 0.26 for the MSCI All Country World Index and 0.17 MSCI EAFE Index. Miskin attributed the better returns to earnings as a key factor in their rebounds after periods of volatility.
Furthermore, while the U.S. dollar has weighed on international equity demand, Miskin argued that the U.S. dollar may be in the topping process. A flat or weaker dollar outlook would help investment demand for foreign equities, and the emerging countries would benefit from cheaper USD-denominated raw materials as they grow their economies.
Nevertheless, investors who are wary of further swings in the developing markets can look to targeted strategies that implement quality controls. Specifically, Joe Hohn, Portfolio Manager for Dimensional Fund Advisors, pointed out that they look to factors that drive expected returns, such as market equity, small-cap company size, value relative price and profitability.
“Academic research has shown that stocks characterized by smaller capitalizations, lower valuations, and higher profitability have delivered higher expected returns over time,” Hohn said.
For example, from the 1990 to 2017, stocks have outperformed T-bills by an average annualized 5.96 percentage points. Small-caps outperformed large-caps by an average annualized 1.76 percentage points from 1989 through 2017. Value outperformed growth by an average annualized 3.41 percentage points from 1989 through 2017. Lastly, highly profitable companies outperformed companies with low profitability by 5.35 percentage points from 1996 through 2017.
While investors may be able to solely focus on a single factor to capitalize on the varying premiums, it is important to follow a diversified or multifactor approach to limit potential downside risks associated with any single factor. These market factors are also susceptible to market cycles, and by combining the factors, investors can have a smoother ride.
For example, the recently launched John Hancock Multifactor Emerging Markets ETF (NYSEArca: JHEM) tries to reflect the performance of the John Hancock Dimensional Emerging Markets Index, which tracks emerging market stocks and weights the securities on a rules-based process that may be referred to as multi-factor investing or smart beta.
The underlying index weights screens components based on smaller market capitalizations; lower relative price as defined by price-to-book; and higher profitability as defined by operating income over book. Companies that exhibit these characteristics will generally receive an increased weight relative to their unadjusted weight. Furthermore, the portfolio includes momentum screens where low momentum securities are flagged for no additional buys.
Financial advisors who are worried about the low volumes in the recently launched JHEM do not need to be concerned. Will Creedon, Director of ETF Capital Markets at John Hancock Investments, explained that JHEM’s trading volume has little to do with an ETF’s true liquidity. Due to the ETF’s innate creation and redemption process, large traders who want to execute big block orders can work with an alternative liquidity provider, an ETF provider’s capital markets team or their brokerage desk to push through the order with a relatively tight bid/ask spread in a low volume ETF without overtly affecting the security’s price.
Financial advisors who are interested in learning more about the emerging market opportunities can watch the webcast here on demand.