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.

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.

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:

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.

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.