A stock board in Brazil. (Photo: AP)

Last year emerging market stocks were far and away the best performers, but year to date they are lagging developed market equities, including the U.S.

The iShares MSCI Emerging Markets ETF (EEM) is down almost 6% and, like many other emerging market funds, suffering huge outflows, while the S&P 500 is up about 4%. On June 19, EEM lost close to $1.5 billion, leading all other ETFs in outflows that day, according to ETF.com.

Overall, emerging market equities suffered outflows of $5.1 billion for the week ended June 20 ), the biggest outflows since November 2016, according to Bank of America Merrill Lynch.

There are several reasons for the decline in emerging markets: a stronger U.S. dollar, which is problematic for emerging companies with dollar-denominated debt; the growing trade dispute between the U.S. and emerging markets, primarily China; and idiosyncratic issues of individual countries. Argentina and Turkey, for example, have large fiscal and current account deficits and double-digit inflation. While the central banks of both countries have raised interest rates sharply to combat rising inflation, those rates — almost 18% in Turkey and 40% in Argentina — could give investors pause.

Also adding to investors’ nerves of late are upcoming elections in Mexico and Brazil. Turkey’s re-election of Tayyip Erdogan on Sunday initially helped strengthen the country’s currency, the lira and stock market, which then retreated from the day’s highs.

Analysts at Morgan Stanley and JPMorgan expect more downside in emerging markets and Wells Fargo Investment Institute’s analyst is neutral.

Nuveen’s chief investment strategist Brian Nick is mixed, underweight Venezuela and Turkey but  more favorable toward Argentina and Brazil. Argentine stocks surged after MSCI announced it was upgraded Argentina and Saudi Arabia to include in its emerging markets index in May 2019.

Despite the short-term volatility — which could presage a bear market in emerging markets this year — many analysts and strategists expect emerging markets will perform well in the long term compared to developed markets. Their economies have much room to grow, and with the primary exception of China, much younger populations, which support long-term growth.

India, which has a young population and growing consumer middle class, is a long-term favorite for Jeremy Schwartz, director of research at WisdomTree.

“The reward is higher so the risk and volatility on the downside is to be expected,” says Todd Rosenbluth, director of mutual & exchange-traded fund research at CFRA. He had recommended at the end of May that investors lighten up on emerging market exposure but not eliminate it from portfolios.

Emerging markets should still play a meaningful role in a broad asset allocation strategy, and investors nervous about more volatility can opt for low-volatility emerging market ETFs, says Rosenbluth.

iShares MSCI Emerging Markets Minimum Volatility Index ETF (EEMV), for example, lost 2.5% year to date through Friday, less than half the loss in the MSCI Emerging Markets Index ETF (EEM), and Invesco’s S&P BMI Emerging Markets Low Volatility Index ETF (EELV) lost 2.9% year to date.

Of course, the two low-vol ETFs also gained less over the past 12 months compared to EEM: 8.26% and 6.39% versus 9.47%.

EELV invests in the 200 least volatile stocks with its benchmark index; EEMV is limited in the extent it can limit its exposure to stocks in the broader index.

Looking at the breakdowns by country, China accounts for 35% of the assets of EEM, 28% of the asset of EEMV but only 10% of the assets of EELV. The Invesco ETF has a 30% exposure to Taiwan and only 4% exposure to South Korea.

While China and its stocks may be the most vulnerable to a trade dispute with the U.S., other countries and their companies are likely to be affected because of global supply chains, including the U.S., which is also vulnerable  to retaliation by China.

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