For years, the once-hot growth BRIC countries — Brazil, Russia, India and China — and other emerging markets had turned into middling investments at best, and downright dogs at worst.
From the start of 2012 through the end of 2015, funds tethered to the BRIC countries languished. Brazilian stocks lost some 65 percent while Russian equities shed 45 percent. Sure, Indian and Chinese stocks were up, by 3 percent and 11 percent, respectively, but the Standard & Poor’s 500 index charged ahead by more than 60 percent over the same period.
This year has been a different story. While the S&P 500 has rebounded 14 percent from its February lows, Indian stocks have roared ahead by 19 percent, Chinese and Russian stocks have ripped off respective gains of 28 percent and 34 percent. And lowly Brazil? It’s working on a doubler, up 87 percent for the year amid the impeachment of scandal-plagued President Dilma Rousseff and renewed hopes for economic reform.
[See: 10 Great Ways to Buy Emerging Markets.]
As a result, the iShares MSCI Emerging Markets ETF (ticker: EEM) — the oldest broad emerging markets fund, and the second-largest by assets at more than $30 billion — has soared 22 percent since mid-February. That has the EEM on pace to outperform the index for the first time in five years.
The question is, how much do emerging markets have to give, and should you trust EEM to deliver?
Keep riding the hot hand. The main investment thesis behind emerging markets has always been the promise of outsize economic growth compared to their developed brethren. But the other edge to that blade is the market’s violent negative reaction to slowdowns in that growth.
Bearish headlines decry slowing growth in China and India, despite both countries still producing 7 percent GDP growth or more. That’s a lot better than the mid-2 percent GDP improvement from the U.S. over the past few years, but global investors were less worried about America’s consistently slow growth compared to those emerging market’s downward trend.
Meanwhile, lower prices for commodities such as oil and gold have hampered emerging markets such as Brazil and Russia, whose economies are strongly tethered to production.
But much of that is changing.
Oil and gold have both bounced back strongly in 2016, putting a charge back into Russian and Brazilian equities — a trend that JJ Feldman, portfolio manager at Miracle Mile Advisors in Los Angeles, sees continuing.
“We think emerging-market economies stand to benefit from higher commodity prices and lower-for-longer (interest) rates,” he says. “We expect oil to stabilize around $50 with the potential to appreciate as high as $70 in 2017, which will help the oil exporter giants such as Russia.”
[Read: Why China Should Be Part of a Long-Term Investment Portfolio.]
China has seen economic growth improve, and even slower-paced South Korea is managing to top forecasts and stretch market optimism.
“It appears as if some of the headwinds for these markets are dissipating,” says David Twibell, president of Custom Portfolio Group in Englewood, Colorado. “China’s growth, while nowhere near where it was a decade ago, has stabilized somewhat. And we’re even starting to see better growth in many of these countries relative to the U.S. and other developed markets.
That would seem to be a ringing endorsement for EEM … but it’s not.
Where EEM succeeds, and where it fails. The iShares MSCI Emerging Markets exchange-traded fund is a widely held emerging-markets fund that has become almost a proxy for the space.
The EEM tracks the MSCI Emerging Markets Index, resulting in a basket of roughly 850 equities across 27 countries. The U.S. is included because while “exposure” mostly is determined by where the companies are headquartered, iShares points out “in some instances it can reflect the country where the issuer of the securities carries out much of their business.”
So EEM provides decent diversification. But the experts also say it has some fundamental flaws.
“The EEM is one of the easiest ways to invest in emerging markets, but it’s not necessarily the best,” Twibell says. “EEM uses a capitalization-weighted approach to selecting stocks, meaning it invests more money in larger companies and less in smaller ones. That’s OK, but it tends to lead to a relatively geographically concentrated portfolio.”
It absolutely does. More than a quarter of EEM’s weight is dedicated to China. However, given China’s still-robust growth, that’s not nearly as troubling as the combined 27 percent weight in South Korea and Taiwan, which deliver low 3 percent and 1 percent GDP growth, respectively.
Meanwhile, India — which Feldman likes because its “demographics are trending towards a younger, larger population which will drive consumption” — and its 7 percent GDP growth are represented at just 8.4 percent of the fund. Any exposure to commodity-spurred growth will be muted, too, as Brazil is weighed at less than 8 percent and Russia sits below 4 percent.
David Fabian — managing partner and chief operations officer of FMD Capital Management in Irvine, California — points out another core flaw that was echoed by his peers: price.
“One of the most detrimental aspects of this fund is its 0.68 percent expense ratio, which ranks much higher than many competitors,” he says. “Vanguard Emerging Market ETF ( VWO), for instance, only charges a 0.15 percent expense ratio and gives you access to a pool of 4,272 stocks versus 850 in the large cap-dominated EEM.”
Where the experts diverge is the question of, if not EEM, where should your emerging-market allocation go?
Fabian suggests going lower-cost because “over time, these fees can add up and potentially weigh on your returns. In addition to VWO, Fabian likes the iShares Core MSCI Emerging Market ETF ( IEMG), which owns 1,900 companies and charges just 0.14 percent annually.
Twibell likes the Schwab Emerging Markets Equity ETF ( SCHE), which charges 0.13 percent and has slightly less weight in China and Taiwan than EEM, plus it excludes South Korea entirely. But he also points more aggressive investors toward the PowerShares DWA Emerging Markets Momentum Portfolio ( PIE), an actively managed fund that typically provides greater exposure to smaller emerging countries.
“PIE currently has a 19 percent weighting in Thailand and a 10 percent weighting in the Philippines — two areas that are barely rounding errors in EEM,” he says.
[See: 8 Great ETFs That Hold ETFs.]
Feldman even suggests going more conservative with the iShares Edge MSCI Min Vol Emerging Markets ETF ( EEMV), which “has double the exposure to emerging market large-cap stocks” and features a 25 percent lower three-year standard deviation than EEM. Yes, EEMV charges a base 0.69 percent expense ratio, just like EEM … but it has waived those fees down to 0.25 percent through the end of 2023.
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Emerging Markets Will Stay Hot, But Will EEM? Maybe Not. originally appeared on usnews.com
