Wiser Research – Emerging Market ETFs

Definition

Emerging markets are defined as those nations with social or business activity in the process of rapid growth and industrialization.  They have a relatively short history of open market relations and foreign investment.  Emerging market is characteristic of a country that has previously had a centrally planned and isolated economy, generally due to long-standing one-party political and socioeconomic systems, or a developing nation emerging from poverty or economic sanctions.

Currently, there are more than 40 emerging markets in the world, with China and India considered the largest.  The ASEAN – China Free Trade Area, launched January 1, 2010, is the largest regional emerging market in the world.  The stock markets of any given emerging market tends to be more volatile than a more established market.

Frontier markets are a subset of emerging markets, and includes countries that have lower market capitalization and liquidity than more developed emerging markets.  They are generally expected to increase in liquidity as their markets further develop, and will exhibit similar risk characteristics as larger, more liquid developed emerging markets.

Classification of countries as either emerging or frontier markets can vary.  The two main classification systems are provided by FTSE Group and MSCI Barra.  FTSE further classifies emerging markets as advanced or secondary by gross national income (GNI).  Advanced markets include upper middle income GNI countries with advanced market infrastructures or high income GNI countries with lesser developed market infrastructures.  Secondary markets include upper middle, lower middle and low income GNI countries with reasonable market infrastructures and significant size, and some upper middle income GNI countries with lesser developed market infrastructures.

The following chart identifies where countries are classified, based on system.  Notice that some countries are included on one system but not the other, and some are considered emerging on one system, but considered frontier on the other.

FTSE

MSCI Barra

Advanced Emerging Markets Secondary Emerging Markets Frontier Markets Emerging Markets Frontier Markets
Brazil Chile Argentina Brazil Argentina
Hungary China Bahrain Chile Bahrain
Mexico Columbia Bangladesh China Bangladesh
Poland Czech Republic Botswana Columbia Bulgaria
South Africa Egypt Bulgaria Czech Republic Croatia
Taiwan Indonesia Cote d’Ivoire Egypt Estonia
Malaysia Croatia Hungary Jordan
Morocco Cyprus India Kazakhstan
Pakistan Estonia Indonesia Kenya
Peru Jordan Malaysia Kuwait
Philippines Kenya Mexico Lebanon
Poland Lithuania Morocco Lithuania
Russia Macedonia Peru Mauritius
Thailand Malta Philippines Nigeria
Turkey Mauritius Poland Oman
UAE Nigeria Russia Pakistan
Oman South Africa Qatar
Qatar South Korea Romania
Romania Taiwan Serbia
Serbia Thailand Slovenia
Slovakia Turkey Sri Lanka
Slovenia Trinidad and Tobago
Sri Lanka Tunisia
Tunisia Ukraine
Vietnam UAE
Vietnam

 

Impact on World Economy

From 2003 to 2009, emerging markets grew from 4.5% to 13% of the weighting in the MSCI All Country World Index.  At the same time, the US percentage dropped from 52.5% to just under 42%, while all developed countries dropped from 95.5% to 87%.

In terms of ranking, in 1987, only Brazil ranked among the top 10 nations by GDP weight, landing at # 8.  By 2008, China entered the mix landing in the # 3 spot.  By 2030, it is projected that BRIC countries (Brazil, China, India, Russia) will account for almost 25% of world GDP.

Rank

1987

2008

2030*

Country

GDP Wt

Country

GDP Wt

Country

GDP Wt

1

United States

30.1%

United States

26.7%

United States

22.8%

2

Japan

16.2%

Japan

9.1%

China

15.5%

3

Germany

6.6%

China

6.3%

Japan

5.2%

4

United Kingdom

4.9%

Germany

6.1%

Germany

4.3%

5

France

4.5%

United Kingdom

4.8%

India

4.2%

6

Italy

3.9%

France

4.6%

United Kingdom

3.7%

7

Canada

2.3%

Italy

3.6%

France

3.3%

8

Brazil

2.1%

Canada

2.6%

Brazil

2.6%

9

Spain

1.8%

Spain

2.5%

Russia

2.4%

10

Russia

1.7%

Brazil

2.3%

Italy

2.3%

According to global management consultancy McKinsey & Co. in April 2011, seven emerging economies – China, India, Brazil, Mexico, Russia, Turkey and Indonesia – are expected to contribute about 45% of global GDP growth in the coming decade.

Impacts on Emerging Markets Performance

Emerging markets tend to exhibit higher volatility, and the quality of economic and financial data from emerging countries tends to be less robust than that of developed markets.  Performance can be impacted by politics, socioeconomic developments and environmental factors.  Investments in the Middle East took a hit due to the political unrest that started in Egypt in early 2011 and spread to neighboring countries, while oil investments surged upwards.  Investments in Japan also took a hit due to the March earthquake and tsunami.  In the case of the Japan earthquake, the markets of South Korea experienced an increase, led by automobile makers such as Hyundai and Kia who were poised to fill the void left by Toyota’s forced manufacturing hiatus.

The Future of Emerging Markets and Benefits to Portfolios

Emerging markets are growing rapidly, more so than in developed markets.  In select frontier markets, growth is even faster, and also exceeds the growth in developed markets by a wide margin.  However, historically we’ve seen a low correlation between GDP growth and stock market returns.  Correlation between GDP growth and emerging market stock returns for 16 countries between 1990 and 2002 is negative .37, and moves to zero from 1950 to 2002.  In 21 emerging markets, stock returns and GDP growth had a correlation of negative .298 from 1999 to 2007.   However, growth is not only economic but also expansion in the breadth and depth of capital markets.  Some markets are becoming larger and more liquid, a plus for investors concerned about investment movement restrictions in emerging markets. Positive fundamentals could potentially enhance performance as well.

One risk is that things can change very quickly.  Due to the regional crises in the Middle East and Japan in February and March, we saw significant investment outflows from emerging markets; a scant two months later, the trend reversed.

What we are beginning to see is increased cooperation among the larger emerging markets.  For instance, Brazil and China recently entered into a number of economic and investment accords in areas such as energy, agriculture, defense, and technology.  South Korea and Peru finalized a free trade agreement aimed at boosting trade and economic relations.  Also, the larger emerging markets such as the BRIC countries are becoming more like developed markets, as they are investing into frontier markets in the areas of construction, transportation, telecommunications, banking and finance.

While individual emerging markets can be more risky than other investments, broad diversification lowers risk.  A properly diversified portfolio that includes emerging markets may see less volatility than one invested solely in developed markets.

During our research we found that the best correlation for the emerging markets fund VWO, which best tracks the MSCI EM Index and FRN, representing the BONY EM Frontier Index was US Small Caps. We often hear that Emerging Markets are tied to commodity prices. We found the following:

Correlation Calculations:
VWO & OIL

0.103960082

VWO & IJR

0.924662378

VWO & DJP

0.580397057

 

Correlation Calculations:
FRN & OIL

0.311849055

FRN & IJR

0.913880227

FRN & DJP

0.714891696

 

Comparison of Specific Emerging and Frontier Markets ETFs

Funds chosen for analysis include emerging market and frontier market ETFs with over $100 million in assets under management.  A total of 14 emerging market ETFs and one frontier market ETF were considered.  The oldest such ETF is nine years old; most are in the 3-4 year range, while a few were established within the last year.  Of the 15 funds, there is very little duplication of associated benchmark indices.  A summary chart of all funds can be found in the Appendix.

Hypothetical Model Portfolios

While a truly diversified portfolio will include emerging markets as a portion of the total investment holdings, for the purpose of this report, we created a model portfolio with purely emerging market ETFs.

To start, we narrowed the list of ETFs to consider to five, based on high Sharpe ratio, low expense ratio and diversification (more than 100 holdings):  EEM, VWO, EWX, DGS, and DEM.  We also included FRN because it is the only one of its asset class.  When looking at the three-year Sharpe ratios, all but FRN were in the top five among all funds (FRN being too new to have a Sharpe ratio).  EEM, VWO, EWX, DGS and DEM had significantly higher Sharpe ratios than the rest of the funds.

EEM and VWO are similar and provide a large-cap blend investment style and broad country diversification.  EWX provides exposure to large- and mid-caps, with concentrations in Latin America, and Middle East/Africa.  FRN is similar in exposures to EWX, just in the frontier markets.  DGS provides a mid- and small-cap value style with concentrations in developed and emerging Asia and Middle East/Africa; it has a dividend yield around 3%.  DEM invests in high-quality large-caps and has a dividend yield in the 3-4% range.

As for regional concentrations, EEM, VWO and DGS all have significant concentrations in Asia.  FRN, in contrast, has large concentrations in Latin America.

Region

EEM

VWO

DGS

FRN

Asia Developed

27.04%

25.57%

31.79%

0.00%

Asia Emerging

32.09%

32.80%

27.37%

7.84%

Latin America

20.99%

22.16%

16.20%

62.70%

Europe Emerging

11.70%

11.41%

7.70%

9.23%

Africa/Middle East

8.16%

7.82%

16.95%

19.28%

When we look as specific countries, EEM and VWO have virtually the same concentrations in the same countries of China, South  Korea, Taiwan,and Brazil.  DGS shows similar preferences for Asia, with Taiwan, South Korea, and Thailand, with South Africa thrown into the mix as well.  FRN’s top countries, on the other hand, are the Latin American countries of Chile, Columbia, and Argentina, as well as Egypt.

EEM

VWO

DGS

FRN

China

17%

China

17%

Taiwan

19%

Chile

34%

Brazil

15%

Brazil

15%

South Korea

11%

Colombia

13%

South Korea

15%

South Korea

15%

South Africa

9%

Egypt

10%

Taiwan

11%

Taiwan

11%

Thailand

9%

Argentina

7%

For market capitalization of investments, EEM and VWO have a slant towards giant- and large-cap stocks.  DGS is more heavily concentrated in mid- and small-caps.  FRN shows a preference for large- and mid-cap stocks.

Size

EEM

VWO

DGS

FRN

Giant-cap

44.56%

44.85%

0.86%

9.20%

Large-cap

39.32%

39.60%

7.00%

37.44%

Mid-cap

15.29%

15.04%

59.20%

44.15%

Small-cap

0.69%

0.51%

31.83%

8.92%

Micro-cap

0.14%

0.00%

1.12%

0.29%

Using this narrowed list, we created three hypothetical model portfolios for comparison:

Portfolio 1

Portfolio 2

Portfolio 3

EEM / VWO

33.4%

EEM / VWO

50.0%

EEM / VWO

60.0%

DGS

33.3%

DGS

35.0%

DGS

40.0%

FRN

33.3%

FRN

15.0%

Portfolios 1 and 2 are essential the same except for differences in fund concentrations.  Portfolio 1 is equal weighted, while Portfolio 2 is designed with a preference for EEM/VWO, followed by DGS, and a small percentage in FRN.  Portfolio 3 leaves out FRN.

EEM is the fund used in these portfolios.  We chose EEM because of its long-term track record, but actually prefer VWO.  VWO performs similarly to EEM, does not use optimization and therefore tends to track its index better, and has a lower cost.  Also, portfolios 1 and 2 have two snapshot versions:  one uses the actual FRN fund; the other uses its benchmark BONY Emerging Markets ADR TR USD, due to the lack of historical performance data for the relatively new FRN fund.

While not included in the hypothetical portfolios, for portfolios where income is needed, DEM may be a good addition.  DEM is exposed to non-US dollar assets and does not hedge its foreign currency risks.

In terms of hypothetical performance of the three models, the numbers show mixed results.  For one- and three-year returns, Portfolio 3 tops the list, while Portfolio 1 leads the five-year return.  Sharpe ratio and mean show similar results, with Portfolio 3 leading at the three-year mark and Portfolio 1 leading at the five-year.  Standard deviation shows different results, with Portfolio 1 having less volatility at three years, and Portfolio 3 having less at five years.

Returns

Sharpe Ratio

Standard Deviation

Mean

Portfolio

1-YR

3-YR

5-YR

3-YR

5-YR

3-YR

5-YR

3-YR

5-YR

1 *

29.26

3.13

13.58

0.24

0.55

30.50

26.34

3.13

13.58

2

30.40

3.75

13.24

0.26

0.54

30.60

26.30

3.75

13.24

3

31.61

4.62

13.12

0.29

0.53

30.66

26.26

4.62

13.12

* Benchmark index BONY Emerging Markets ADR TR USD used, as FRN is too new for useful performance data.

The chart below is a break down of portfolios by region. By removing FRN in portfolio 3, we see an increase in Asian exposure and a decrease in Latin America.

Region

Portfolio 1

Portfolio 2

Portfolio 3

Asia Developed

19.54%

24.62%

28.97%

Asia Emerging

22.34%

26.73%

30.17%

Latin America

33.45%

25.65%

19.05%

Europe Emerging

9.27%

9.80%

10.08%

Africa/Middle East

14.72%

12.90%

11.72%

When we look as specific countries, portfolios 1 and 2 show preferences for China, Taiwan, and South Korea, and include only a bit of Latin American investment concentrated in Brazil.  Portfolio 3 has significant investments in the same Asian countries, but adds higher amounts of Latin American countries such as Chile, Columbia, and Argentina.

Weighting by Country (listed in descending order)
Countries Model Portfolio 1 Model Portfolio 2 Model Portfolio 3
Other Countries 15.818538 Taiwan 12.695 Taiwan 14.82
Chile 13.77878 South Korea 11.0965 South Korea 13.094
Taiwan 10.53337 Brazil 10.7955 Brazil 12.772
South Korea 8.507259 China 10.599 China 12.616
Brazil 8.110709 Chile 7.618 South Africa 8.414
China 7.581002 Other Countries 7.539 Thailand 5.08
South Africa 5.746851 South Africa 7.1725 India 4.635384615
Thailand 3.93312 Thailand 4.4 Russia 4.446
Turkey 2.843195 India 3.863461538 Malaysia 3.86
Malaysia 2.740012 Russia 3.7055 Turkey 3.704
Argentina 2.706396 Malaysia 3.306 Israel 2.92
India 2.579999231 Turkey 3.2045 Mexico 2.692857143
Russia 2.473825 Israel 2.555 Chile 2.676
Israel 2.43309 Mexico 2.245 Indonesia 2.28
Poland 2.233283 Indonesia 1.9395 Philippines 1.646
Indonesia 1.530069 Poland 1.7205 Poland 1.258
Mexico 1.502675714 Philippines 1.4255 Other Countries 0.72
Philippines 1.273265 Argentina 1.3 Hungary 0.268
Pakistan 0.796587 Czech Republic 0.776 Czech Republic 0.25
Hungary 0.150029 Pakistan 0.3585 Argentina 0.164
Czech Republic 0.143358 Hungary 0.2235 Hong Kong 0.156
Hong Kong 0.086684 Hong Kong 0.13 United States 0.138
United States 0.076682 United States 0.115 Pakistan 0

For market capitalization of investments, all three portfolios show a skew towards large- and mid-cap stocks, with Portfolio 1 showing a slightly more even spread between the two.

Size

Portfolio 1

Portfolio 2

Portfolio 3

Large-cap

47%

53%

53%

Mid-cap

39%

35%

33%

Small-cap

14%

12%

14%

Summary Analysis of Hypothetical Portfolios

Choosing an optimal portfolio depends on the investor’s objective(s).  Some investors are more concerned about risk and reward, while others are more concerned about being widely diversified. Diversification is important, but investing in a “unhealthy” asset class could be more risky than a less diversified portfolio.

For risk/reward objectives, results are mixed among the three portfolios depending on whether one considers the three-year or the five-year data.  Essentially, Portfolio 3 looks better using three-year data, while Portfolio 1 looks better with five-year data.

All portfolios show a strong preference for Asia, each having roughly 50% of the total portfolio invested in that region between developed and emerging markets.  The use of FRN in portfolios 1 and 2 adds significant investment in Latin America to the mix.  This report includes 30 % and 15% of FRN in the total portfolio of portfolios 1 and 2.  Having an even higher percentage of the total portfolio invested in FRN would dilute the Asian influence and increase the Latin American cut, providing broader diversification.  One should also consider, however, the long-term health of the countries in which FRN is concentrated, and if such a concentration is appropriate, when compared to the outlook of the Asian markets.

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