More To EM ETFs Than China

July 10, 2018

With China comprising 30% of the MSCI Emerging Markets Index, and soon to take up 40% once all the mainland Chinese stocks are added (known as A-shares), the Asian nation will dominate the index.

Since some of the biggest emerging market exchange-traded funds—like the iShares Core MSCI Emerging Markets ETF (IEMG), with $46.7 billion in assets under management (AUM), and the iShares MSCI Emerging Markets ETF (EEM), with $31 billion in in AUM—follow the MSCI index, that can significantly tilt portfolios toward China (Figure 1).

Figure 1: EEM Country Breakdown

Emerging market asset allocation in portfolios is usually small, so having one nation dominate the makeup of a popular index may adversely affect returns. Some financial advisors may want to consider ways to offset China’s influence, whether as a strategic or tactical decision.

There are a few ways to blunt the impact China has on emerging market asset allocation: by using the few ETFs that specifically exclude China, using an equal-weight ETF like the Invesco MSCI Emerging Markets Equal Country Weight ETF (EWEM) or using single-country ETFs.

Alternatives To The Traditional
The downside of using the equal-weight or ex-China ETFs is they have low AUM, says Rick Wedell, chief investment officer at RFG Advisory. EWEM has $12.6 million in AUM, the iShares MSCI Emerging Markets ex-China ETF (EMXC) has $9.6 million and the Columbia EM Core ex-China ETF (XCEM) has $8.7 (Figure 2).

Figure 2: EMXC Country Breakdown

When choosing a single-country ETF to offset Chinese exposure, Wedell says it takes time to go through the different countries because “each one of them has its own nuanced behavior.”

Several ETF experts say advisors should think about the role a single-country emerging market ETF will play in the portfolio. Is it a commodities producer, demographics-driven, technology-focused, a country with a similar profile as China, or the opposite? Since emerging markets aren’t a monolithic region, advisors need to consider all of these factors.

“They’re quite different. If you look at South Korea or Taiwan, they’re exporting countries, while India is more like an importing country. Especially now with the different … trade wars and everything that’s happening right now, it really matters where you put your bet,” said Dina Ting, senior portfolio manager for global ETFs at Franklin Templeton, which offers single-country ETFs.

Chris Dhanraj, head of ETF investment strategy for iShares, says exchange-traded product flows this year at iShares suggest investors are looking to diversify out of the broad emerging market ETPs. In the past three months (as of June), there was $5.9 billion in U.S. ETP outflows from the broad emerging market products, and some of that is likely tied to worries about China as tensions about possible trade wars with the U.S. rise, he says.

Broad emerging market ETPs may be witnessing outflows, but single-country ETFs are receiving inflows as investors seek to diversify away from China, he says. Brazil is a recipient of that investor interest, Dhanraj notes, with the iShares MSCI Brazil ETF (EWZ) seeing $290 million in inflows in the past three months. EWZ has $6.6 billion in AUM.

“It shows you that investors are actually putting money to work in select countries that have favorable outlooks despite rising interest rates [in the U.S.] and trade war tensions,” he explained.

Brazil’s Appeal
Ting also says Brazil has a lot going for it right now, but is undervalued as currency fluctuations have weighed on values. Many investors shied away from Brazil for the past few years due to scandals at the government-owned oil producer Petrobras, and an impeachment of its former president. But Brazil’s had five quarters of positive growth, inflation is under control and the government is undergoing reform, she says. As a commodity producer, rising oil prices helps Brazil.

“It also has the benefit of a relatively young population coming into the middle of class,” Ting said. “So consumer spending is going to help them in terms of domestic growth.”

The devaluation of Brazil’s currency, the real, has impacts for a U.S. investor, but there looks to be a commitment from the government to help alleviate the currency issues and stop the bleeding, she says.

“I think the pricing right now is as if things are going to be a complete disarray,” Ting added. “So I think it's a bit overdone on that front.”

Todd Hoffman, founding partner at Steward Partners, says Brazil could also benefit from a U.S.-China trade war as the Asian nation could turn to Brazil for commodity products like soybeans.

Commodities: Saudi Arabia’s Potential
Hoffman, and Joe Barrato, CEO of Arrow Funds, say commodity producers, especially those in the energy sector, may be a way to diversify away from China. Specifically, Barrato says Saudi Arabia has been up about 20% in the past three months ending June and the best-performing country.

Unlike other emerging market countries, Saudi Arabia’s currency is pegged to the U.S. dollar, minimizing the foreign-exchange fluctuations.

Dhanraj says Saudi Arabia is “quite topical” right now. Part of the strength was anticipation of the country being added the MSCI EM benchmark. The index provider added Saudi Arabia at a 2.6% weighting in June, which Dhanraj says “is very, very significant.”

Other factors also drive Saudi Arabia’s growth, such as the country’s Vision 2030 initiative, a major reform agenda to reduce its oil dependence, improve public services and privatize certain business activities. Plus, Saudi Arabia is expected to publicly list the world's most valuable company, Saudi Aramco, the state-owned oil company.

Saudi Arabia’s story shows what investors want, he says, which is “idiosyncratic stories with good fundamentals, and with a lesser correlation to the broader emerging market story in case there are EM head winds.”

Figure 3: Performance Of EEM, EMXC, KSA, EWZ (7/26/2017-6/29/2018)

Source: Bloomberg

India As An Alternative
Scot Lance, managing director of Titus Wealth Management, says the jitters investors may have over a possible trade war between the U.S. and China are likely to be uglier in the short term, but hopefully it will represent opportunities for longer-term investment.

If the correction in emerging markets continues, he says the region he likes is India. The country has the highest gross domestic product growth of all the biggest emerging markets, Lance says. If the downdraft in emerging markets continues, he says he’s looking to overweight shares of India.

Lance says his firm uses the iShares MSCI India ETF (INDA), which has $4.8 billion in AUM, to get exposure to India. India is moving on a different trajectory from China, he says. Like any emerging market economy, India has its own political issues, but he notes that the country’s banking reforms are positive and there’s a lot of infrastructure development occurring with road and bridge construction. That’s allowing the “suburbanization of the whole country,” Lance adds.

The International Monetary Fund projects India’s growth at 7%, he says, and that could increase: “It’s moving north versus that of China, a significantly larger economy, which is decelerating from that 7% to 6.8% and could drop down even further.”

 

 

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