Emerging market stocks have had a rough decade. 3 year annual returns are flat and even long term 10 year annual returns are barely over 1.5%. But there is new life appearing in the emerging markets. This year the FTSE Emerging Market Index is up 18%, breaking a long term downtrend:
Are emerging markets turning the corner?
What’s the best way to invest in emerging markets? We take a look at a few options:
h/t Reformed Broker for the chart.
So what is the appeal of emerging markets today? First of all, valuation. At a time when we can all agree the U.S. markets appear expensive to historical norms, emerging markets are much cheaper. The S&P 500 currently trades at a P/E Ratio of 22, while emerging markets trade at a much more reasonable 14. The S&P 500 currently trades at a Price/Book ratio of 3, emerging markets trade at nearly half that at just 1.7. Growth comes cheaper too; emerging markets as a whole are seeing earnings growth of 10%, compared to about 8.1% for the S&P 500.
On top of more favorable valuation, emerging markets provide good diversification as well. According to iShares, the MSCI Emerging Markets Index has a correlation with the S&P 500 of 0.01, effectively 0.
Investing in Emerging Markets
There are several ways investors today can invest in emerging market stocks. The most popular by far is using a passively managed index fund. But there are other options as well, investors today have options of actively managed funds, currency-hedged funds, low volatility funds, dividend funds and even factor based emerging market funds. Let’s take a look:
First, Low Cost Passive Emerging Market Index Funds
Below are the 3 largest passively managed emerging market index funds. They are low cost, have very high liquidity and are run by some of the most trusted names in investing today. But even between just these 3 index funds, there are some differences:
VWO – Vanguard Emerging Markets ETF
- Expense Ratio of 0.14%
- Tracks the FTSE Emerging Markets All Cap China A Inclusion Index Index
- 4619 Holdings
- Dividend yield of 2.21% (based on last 12 months of dividends)
- Pays a quarterly dividend
- Trades commission free with Vanguard and TD Ameritrade brokers
Vanguard’s emerging market ETF is the largest in the industry with more than $76 billion in assets. The fund is also more broadly diversified than the funds of their competitors with over 4600 holdings. It is also the only passively managed ETF here that pays a quarterly dividend, if that matters to you.
SCHE – Schwab Emerging Markets Equity ETF
- Expense Ratio of 0.13%
- Tracks the FTSE Emerging Index
- 732 Holdings
- Dividend yield 2.25%
- Pays an annual dividend
- Trades commission free on Charles Schwab platform
Schwab has been fighting to compete with Vanguard, and they have got to where their low cost index funds can go toe to toe with Vanguard. Schwab and Vanguard continuously fight for the title of “lowest cost” index fund in a number of asset classes. Here Schwab bests Vanguard by 0.01%.
IEMG – iShares Core MSCI Emerging Markets ETF
- Expense Ratio of 0.15%
- Tracks the MSCI Emerging Markets Investable Market Index
- 1867 Holdings
- 2.01% Dividend yield
- Pays a semi-annual dividend
- Trades commission free on Fidelity
As similar as it seems these funds would be, there is enough differences in their portfolios to create a notable difference in performance over the last few years:
As far as I can tell, the difference in performance comes from IEMG’s inclusion of South Korean stocks, which adds more exposure to technology and consumer cyclicals, sectors that have been performing well lately. Of course this is no guarantee of future performance.
What To Consider When Investing in Emerging Market Stocks
Volatility in Emerging Markets
Investing in emerging markets adds some additional concerns for investors. Historically, emerging markets have been more volatile than U.S. markets, which may be a turn-off for certain investors. iShares offers one solution:
EEMV – iShares MSCI Emerging Market Minimum Volatility Fund
- Expense Ratio of 0.25%
- Tracks the MSCI Emerging Markets Investable Market Index
- 1888 Holdings
- 2.01% Dividend yield (exactly the same as IEMG)
- Pays a semi-annual dividend
For an extra 0.10% in expenses, EEMV gives investors a less volatile portfolio compared to IEMG with a standard deviation of 12.3% vs 15.75% for IEMG.
Of course the premise of any low volatility fund is to pick securities that have been less volatile in the past, no guarantee that performance continues in the future.
The performance of EEMV leaves a lot to be desired, too:
EEMV performed a little better during the decline at the beginning of 2016, but has lagged significantly since the start of this year. Ultimately, I don’t think low volatility funds are that useful. There is no guarantee they will perform in the future, they typically cost more and I think they give investors a false sense of security. But I’ve been wrong before….
Currency Fluctuations
Another potential problem for emerging market investors – currency fluctuations. When you buy shares in, for example, China, your dollars are converted to Yuan until you choose to sell and get your investment back, when the Yuan you receive from selling your Chinese shares must then be converted back into dollars. Even if your shares increased in value (in terms of Yuan), if the Yuan was down against the dollar, you will not see the same appreciation in your portfolio.
For that reason, there are several ETFs that hedge against currency moves by purchasing derivatives and currency swaps in an attempt to negate currency fluctuations. The largest is run by iShares:
HEEM – iShares Currency Hedged MSCI Emerging Market ETF
- Expense Ratio of 0.71%
- Tracks the MSCI Emerging Markets 100% USD Index
- 76% Dividend yield
- Pays a semi-annual dividend
What kind of difference in performance do you get from the added expenses and currency hedging? Not much:
Not a ton of difference. Here’s my theory: A broadly diversified emerging market ETF like this one has dozens of currencies associated with its investments. This diversification in currency effectively negates the effect big moves by one or two currencies would have on your total investment. If you are invested in an ETF with holdings in a single foreign country, I think you could make an argument for currency hedging, but when the fund is made up of dozens of currencies, it becomes pointless (and adds a lot of expenses! How much do these added expenses hurt your long term returns? Check out our expense ratio calculator to see).
Who Should Invest in Emerging Market Funds
Even if emerging markets are starting a long term uptrend, they will likely still be volatile. Investors must be comfortable seeing 1 or 2% moves quite often. It seems after a “lost decade” emerging markets are due for some good times, but that doesn’t mean the journey will be easy. Investors should still have a longer time horizon as these stocks can drop significantly any given year.
That said, anyone who considers themselves a value investor would have a hard time not weighting a significant portion of their portfolios in emerging markets today. At a time when so many markets are expensive, emerging markets offer one of the few broadly diversified ways to buy value today.
Emerging markets also provide excellent diversification for investors, as we mentioned above, these funds have a correlation of right around 0 with the S&P 500, a welcome sign for investors worried about future U.S. market performance.
Of course, none of this means emerging markets have to turn around today. A lost decade can easily turn into a lost 15 years. Emerging markets were cheap 3 years ago too, and haven’t done anything since then. But if you have the time, you have to love the chances of getting in at an attractive price here.
