Home etftrends.com VettaFi Voices On: Investing in Emerging Markets

VettaFi Voices On: Investing in Emerging Markets

Emerging markets can come with a lot of growth potential. However, they also usually have more volatility than you might get with developed markets. This week, VettaFi Voices gathered at the water cooler to discuss investing in emerging markets. Should investors be allocating to emerging markets? How much of their portfolios should emerging markets represent? And finally, how should they approach the space?

Todd Rosenbluth, head of ETF research: The iShares Growth Allocation ETF (AOR) is one of the asset allocation ETFs available from a major ETF provider. It has the traditional 60% equity/40% fixed income exposure. Within the equity portion, approximately 25% of total assets are investing in international equities, with 18% in developed international and close to 7% in emerging markets using the iShares Core MSCI Emerging Markets ETF (IEMG). Interestingly, there is no dedicated emerging markets fixed income slice of the portfolio. But AOR does own a 6% slice of the iShares Core International Aggregate Bond ETF (IAGG).

IAGG has roughly a quarter of assets invested in China and South Korean bonds. I use this as an example of what the “easy” approach to getting emerging markets exposure involves. But investing in emerging markets likely requires advisors and end clients to answer some key questions.

Do I want a broad approach like IEMG and the Vanguard FTSE Emerging Markets ETF (VWO); a more targeted approach to reduce the risk through dividends like the WisdomTree Emerging Markets High Dividend ETF (DEM) or the ALPS Emerging Sector Dividend Dogs (EDOG); or lower volatility approach like the Invesco S&P Emerging Markets Low Volatility ETF (EELV)?

Do I want to focus on certain countries thematically the way the KraneShares CSI China Internet ETF (KWEB) or the Emerging Markets Internet & Ecommerce ETF (EMQQ) does, or do I want to accept that I’m excluding countries the way that the Freedom 100 ETF (FRDM) does? Or do I simply want to overweight a single country using ETF like the iShares MSCI Taiwan (EWT) and the Franklin FTSE India (FLIN)? Earlier this year, VettaFi data showed that advisors are interested in India-focused ETFs.

Do I want to hedge the currency risk using the Xtrackers MSCI Emerging Markets Hedged Equity (DBEM) or the Invesco Emerging Markets Sovereign Debt ETF (PCY) that owns U.S. dollar-denominated bonds?

While most advisors are taking a broad approach, there’s strong products that can add value for advisors.

Could Active Managers Add Value?

Heather Bell, managing editor: I think emerging markets are an important source of diversification, so I do think they should be included in a portfolio. However, I also wonder if there shouldn’t be a tactical element to it if you’re going to do a large allocation. I keep saying I’m not a fan of active management, but then I have an exception. I think there’s an opportunity for an active manager to do an actively managed ETF that invests solely in emerging market country ETFs and tactically allocates among them. That kind of ETF-of-ETFs product doesn’t exist right now. An active manager might have had a better chance of getting out of China when it became clear that its zero-COVID policy was unsustainable. Or they might have been able to get out of Russia immediately when — or even before — it invaded Ukraine.

But of course, there’s already a fund that kind of does this via an equity index as you mentioned, Todd — FRDM, which was created by Perth Tolle. It’s got more than half a billion dollars, and it’s been outperforming IEMG pretty handily since its inception. It’s based on metrics related to freedom, which can be a good way to screen out countries that may not be sound investments. It doesn’t own China, and it doesn’t own Turkey right now. However, it does have its top weights in Taiwan, South Korea, and Chile. I’ve always thought it was a really interesting product.

Rosenbluth: I agree FRDM was a pioneer in excluding EM countries for not valuations but values. While it has some new competitors, it has a first mover advantage. Heather, you were also talking about active emerging market ETFs. The Matthews Emerging Markets Equity Active ETF (MEM) and the JPMorgan ActiveBuilders Emerging Markets Equity ETF (JEMA) are a couple of examples. Meanwhile, some active broad international equity ETF have emerging the markets exposure, not just developed markets. For example, the Capital Group International Focus Equity ETF (CGXU) has 11% invested in India, and smaller weights in South Korea and Singapore.

I was talking about IAGG earlier, but the Vanguard Total International Bond ETF (BNDX) has a 7% weight in emerging markets and is currency hedged; that is important to consider.

Currency Hedging Matters

Bell: Someone once told me that if you aren’t using currency hedging in your international bond strategy, then you don’t have fixed income anymore, but something else. From what I understand, EM currencies are more volatile than other currencies. That could make currency hedging extra important for those exposures.

Rosenbluth: There’s strong interest in currency-hedged fixed income or funds that invest in U.S. dollar-denominated sovereign bonds. With that, investors are getting income from foreign issuers without having to worry about the direction of the dollar. EM currencies are definitely more volatile from memory than the euro or the yen. However, investors do not seem as focused on currency-hedging international equities as they once were.

Of course, advisors are more likely to only have EM exposure for growth and aggressive growth-focused clients. There is too much risk for the more conservative strategies.

Emerging Markets’ Vast Potential

Roxanna Islam Swan, associate director of research: For a U.S. investor, I think it’s easier to ignore EM and other international investments and think about things in terms of the U.S., especially because of the size of our economy and stock market. That said, there’s a lot of value behind emerging markets — even on a sector or thematic basis, as Todd mentioned.

I was looking closely at the consumer discretionary sector this past week, for example. And many of the major trends in consumer discretionary like e-commerce and luxury goods are actually driven by emerging markets. China actually has the largest e-commerce market in the world — over twice as large as the U.S. e-commerce market. And on the luxury goods side, China is actually driving a large portion of demand. Large luxury good retailer LVMH (which includes Louis Vuitton, Moet Hennessy, Dior, and more) stated in its most recent earnings call that it expects China to drive growth in 2023 while demand in the U.S. slows.

Rosenbluth: Emerging markets are definitely helping drive spending in U.S. and European companies. But there are many global companies based in emerging markets like Samsung and Taiwan Semiconductor. Those are absent from client portfolios unless you own EM funds.

Islam: I was also looking at fintech ETFs earlier today and was interested in the Amplify Emerging Markets FinTech ETF (EMFQ). It focuses on emerging market fintech in contrast to most of its peers, which focus on developed markets. There seems to be a lot of growth opportunity in tech-related areas, since many emerging markets like China or India have a tech-savvy population. But there is still more opportunity to expand the infrastructure there vs. the U.S. For example, only 24% of people own a smartphone in India vs. 81% in the U.S. (as of 2019 — which is a little outdated, but you get the idea).

Emerging Market Stocks on Sale

Tom Lydon, vice chairman: The past decade has been a sleeper for emerging markets. VWO — the largest EM ETF, with $96 billion — has returned 2.2% annually for the last 10 years. Not too exciting. That’s the bad news. If you feel that EM is a dead zone now and will be in the future, you can continue to stay away like most U.S. investors have for the last five-plus years.

The good news is that the pendulum eventually swings. EM is on sale. The P/E ratio of VWO is 11, while the S&P 500 is 20. EM is almost half off. Chinese stocks are also fairly priced — even the high flyers. KWEB has a P/E of 22. Tencent, Alibaba, and Baidu are also on sale. Many EM portfolio managers I’ve talked to over the past year have said that EM is a generational opportunity. They are licking their chops and thinking their time is coming.

Something else to think about is the U.S. dollar compared to EM currencies. Economic conditions and the threat of other central banks diversifying away from such a high concentration in the USD could provide favorable conditions for EM currencies. Currencies matter, especially in EM allocation.

Take all of this with a grain of salt. However, you don’t want to see EM come back to life and be 100% on the sidelines. Remember when diversification mattered? It will again.

For more news, information, and analysis, visit the China Insights Channel.

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