The resurgence of beaten-up emerging market stocks has been among this year’s biggest turnaround stories. Will it last?
After seven painful years of underperformance relative to developed country stocks from the U.S. and elsewhere, emerging market shares have enjoyed a sharp rebound in 2016.
Stocks in emerging countries like Brazil (EWZ), Malaysia (EWM) and Russia (RSX) have surged from 12% to 28% year-to-date (through April 8 market close) compared to modest single digit gains in U.S. stocks. And now, for the first time in several years, emerging markets sit atop global equity markets.
While the recovery in emerging markets hasn’t completely stopped the bleeding of capital outflows, it’s decelerated the trend. The Institute of International Finance projects net outflows from emerging markets of about $500 billion in 2016, down from around $750 billion in 2015.
Emerging market ETFs can be neatly organized into five general groups: 1) broadly diversified funds, 2) currency-hedged funds, 3) regional funds, 4) leveraged long/short funds, and 5) single country funds. Let’s analyze ETFs from each group.
Emerging market ETFs with broad diversification are building blocks for the core or foundation of client portfolios.
The convenience of broad emerging markets ETFs is that they offer far-flung exposure at a reasonable cost. For example, the Vanguard FTSE Emerging Markets ETF (VWO) charges just 0.15% annually. VWO has almost $35 billion in assets and is the largest emerging markets ETF by assets.
Other funds like the iShares MSCI Emerging Markets Small-Cap ETF (EEMS) offer concentrated exposure to smaller stocks, which have much less influence in popular emerging market indices from FTSE and MSCI where large cap dominated stocks still rule the roost.
Last year, international-equity funds led all category groups in terms of highest inflows for the calendar year, collecting $207.6 billion according to Morningstar. And currency-hedged funds were the principal factor behind the massive inflow of assets.
While currency-hedged ETFs come in two general iterations (single currency and multiple currency), single currency is the more popular among the two. The key objective of these funds is to maintain long equity exposure while hedging or protecting against the negative impact of currency weakness.
For instance, the Deutsche X-trackers MSCI Emerging Markets Hedged Equity ETF (DBEM) provides exposure to global emerging market stocks, while at the same time mitigating exposure to fluctuations between the value of the U.S. dollar and non-U.S. currencies.
Funds that own stocks from single countries are among the oldest types of ETFs. The iShares MSCI Brazil ETF (EWZ) and iShares MSCI South Korea ETF (EWY), for example, were launched in 2000 when there were less than 100 U.S. listed ETFs.
Because most emerging countries tend to have economies that are concentrated in just one, two or three big industry sectors, these types of ETFs end up being sector bets. As a result, single country ETFs are best as complementary building blocks to an investor’s much larger core portfolio.
The regional emerging market ETFs are designed to follow stocks in specific geographic regions of the world. In diversification terms, these types of funds fall right between broad and single country funds.
With around $700 million in assets, the iShares Latin America 40 ETF (ILF) is one of the largest regional emerging market ETFs. ILF owns publicly traded companies in multiple countries located in Central and South America. Top countries represented inside ILF include Brazil (47.05%), Mexico (35.33%), Chile (11.55%), Peru (4.05%) and Colombia (1.78%). The advantage of ILF, like other regionally focused funds, is the ability to own a targeted geographic without taking the substantially higher risk of betting on stocks in single countries.
State Street Global Advisors offers a menu of regional ETFs targeting emerging markets in Asia (GMF), Europe (GUR), and Africa/Middle East (GAF).
Tactically oriented funds that use leverage are attempting to magnify the daily performance of emerging market stocks by 200% or 300%. The bull ETFs aim for long exposure whereas the bear funds are designed for short or inverse exposure.
The Direxion Daily Emerging Markets Bull 3x Shares (EDC) is an example of a long leveraged bull fund. EDC is built to deliver triple or 300% daily exposure to the MSCI Emerging Markets Index. If the index is ahead by 1% on any given day, EDC should gain 3%. On the other hand, if the index falls 1%, EDC will be down 3%.
On the bear side, the Dierxion Daily Emerging Markets Bear 3x Shares (EDZ) aims for triple or 300% daily opposite exposure to the MSCI Emerging Markets Index. If the index is ahead by 1% on any given day, EDZ should fall 3%. On the other hand, if the index falls 1%, EDZ should gain 3%.
Since most leveraged ETFs reset their leverage on a daily basis, their performance over longer periods of time — like weeks or months or years — can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time. This effect can be amplified in markets with high volatility.
A case study by the SEC illustrates the performance extremes of leveraged long/short ETFs.
Between Dec. 1, 2008, and April 30, 2009, a particular index gained 2%. But a leveraged ETF aiming to deliver twice that index’s daily return declined by 6% and an inverse ETF seeking to deliver twice the inverse of the index’s daily return fell by 25%.
For this reason, the proper context for leveraged long/short emerging market ETFs — if you decide to use them — is strictly in the non-core part of a client’s portfolio. Despite the negative media attention, some advisors have experienced success with these types of ETFs.
The ongoing recovery of emerging markets stocks is a positive sign. After several years of being dead money, investors who have patiently held stocks from developing countries are poised for a reward.
By using ETFs, advisors can help their clients to capitalize on the resurgence of stocks from emerging countries.
The broadly diversified funds are excellent portfolio building blocks that offer affordable and tax-efficient exposure. On the other hand, emerging market ETFs that invest in currency hedged strategies, leverage long/short, regional or single countries are best used as complementary pieces to a client’s much larger core portfolio.