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Portfolio > ETFs

Will Emerging Market ETFs’ Outperformance Last?

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Latin America has been capturing the world’s attention for reasons that go well beyond the Olympics and Brazil’s sizzling political scene. Exchange-traded funds (ETFs) that focus on the region and single country-markets are red hot.

According to Morningstar, as of Aug. 30, these funds accounted for nine of the top 10 year-to-date (YTD) performances among international funds.

The top five ETFs, four invested in Brazil and one in Peru, all had 60%-plus YTD returns. Funds investing in Russian and Southeast Asian markets produced YTD returns of over 20% through late-August, as well.

Hot returns attract hot money.

The Institute of International Finance reported on Aug. 22 that emerging market (EM) funds had seen net inflows of “$13.2 billion since late July, bringing the share of EM assets in the portfolios of global mutual fund and ETF investors to 11.7% by mid-August—the highest level in a year.”

As of Sept. 1, the iShares Latin America ETF (ILF), for instance, is up about 33% for the year vs. a gain of 6.5% for the SPDR S&P 500 ETF (SPY). In the last three months, ILF gained 17% vs. 3% for its U.S. counterpart.

Still, this year’s results only offset a weak three-year performance for many EM funds. Among this year’s top 10 ETFs, the 3-year returns ranged from -14.1% to a high of 0.26%.

What’s behind this year’s bull market and are the stellar results likely to continue?

Market Drivers

Higher prices aren’t solely the result of improved fundamentals, cautions Patricia Oey, senior analyst, manager research with Morningstar in Chicago.

More stable commodity prices have helped the outlook for countries like Brazil and Russian.

Valuations in the EM markets were low, and when money starts to flow to these markets, it tends to move into the relatively cheapest markets first. Also, yields are higher in EMs, drawing yield-hungry investors. It’s essentially a question of relative attractiveness.

“It’s just by comparison, not because emerging markets are doing better,” said Oey.

“But by comparison when you compare the developed markets, emerging markets might have a little bit more to offer. The yields are higher and maybe valuations are a little bit cheaper,” he explained.

Tushar Yadava, investment strategist with BlackRock’s U.S. iShares team in New York, believes EMs have benefited from an economic “sweet spot” recently.

The U.S. dollar has remained relatively weak but stable, commodity prices have stabilized, and signs of modest “upticks in global growth and trade” are showing up in the data. Combine those factors with the developed markets’ higher valuations and low (or negative) interest rates and EMs’ relative attractiveness has improved, he says.

What Goes Up…

If the fundamentals behind EMs’ recent moves aren’t that solid, are investors at risk for an equally volatile move to the downside?

Higher U.S. interest rates could be a headwind, says Oey.

“If there’s a risk-off or if the U.S. begins tightening and investors are able to get some reasonable yield here and, of course, the U.S. is much safer to invest relative to emerging markets, then people will think twice (about EMs),” he stressed.

Short-term thinking backfires with EMs, Yadava cautions, arguing that these markets have worked as expected for long-term investors willing to take on higher risk for higher returns. In reality, though, investors have shown little patience.

“People are all-in when it’s a time like this and it’s fantastic and then they’re all-out when the tide has turned the other way,” he explained. “And that all-in/all-out has really left you very, very scarred and it’s left people very under positioned in emerging markets.”




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