After having underperformed developed market stocks for years, emerging markets and related exchange traded funds could be shifting into a period of outpeformance.
Emerging markets may have moved past a three-year period of dramatic underperformance and is firing back up, according to Christopher Gannatti, Associate Director of Research at WisdomTree.
The emerging economies experienced a a number of setbacks over the past few years. For instance, previously weighing on the developing market outlook, the currency headwind or the U.S. dollar’s appreciation compared to the collective emerging market currencies of more than 21% neutralized positive equity returns.
Moreover, the Federal Reserve pushed the target for its Federal Funds Rate up, adding to a stronger U.S. dollar outlook, which weighs on emerging market equities. Other concerns include how low the price of crude oil has gotten and the possibility of a hard landing in China that could destabilize growth.
“Very few were itching to allocate to emerging markets, but what’s clear is that since then, the MSCI Emerging Markets Index has outperformed the S&P 500 Index,” Gannatti said in a note, pointing out that many have become underallocated to the growing emerging market story.
For instance, Gannatti pointed to the small-cap oriented WisdomTree Emerging Markets SmallCap Dividend Fund (NYSEArca: DGS) as a relatively underappreciated and outperforming emerging market strategy. DGS has delivered nearly two times the return of the S&P 500 Index in the three year period as of December 31, 2015.
With emerging markets rebounding, some may be worried that they have missed the bus, but Gannatti pointed to attractive valuations that may leave more room for emerging stocks to run.
Specifically, DGS’s underlying portfolio shows a forward price-to-earnings ratio below 12.0x, whereas U.S. small-cap equity indices trade over 21.0x. The low valuations may reflect the more cheaply valued small-cap segment of the emerging market, compared to the U.S. market, even after small-cap EM outperformed small-cap US over the past 15 months.
Moreover, DGS’s portfolio shows a dividend yield of more than 4.3%, or more than twice the dividend yield of commonly followed U.S. market cap-weighted indices, which helps investors further generate greater overall returns.
Looking ahead, Gannatti said investors should closely watch a number of catalysts that could further support the emerging market story. For example, the Fed has signaled it could raise rates at least two more times this year, but the U.S. dollar has remained depressed, a positive indicator for the developing markets.
While crude oil and commodity prices have faltered, small-cap emerging markets may avoid the negative impact as large state-run firms are more exposed to commodity prices.
Additionally, investors may want to focus on small-caps since they are more directly tied to a growing emerging consumer base, with most of these companies generating revenue from their domestic markets.
“With the bulk of global population in emerging markets, many investors whom we speak with—even those nervous about emerging markets—recognize that the emerging market consumer will be an important force propelling global growth in the coming decades,” Gannatti added.
DGS tries to reflect the performance of the WisdomTree Emerging Markets SmallCap Dividend Index, which is a fundamentally weighted index that measures the performance of small-cap stocks and are weighted based on annual cash dividends paid.
Top sector weights include consumer discretionary 16.4%, information technology 15.7% and industrials 14.6%. Top country weights include Taiwan 24.9%, China 15.1% and Thailand 11.0%.
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