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.