Emerging Market ETFs Require Due Diligence

July 13, 2017

Todd Rosenbluth is director of ETF and mutual fund research at CFRA.

Investors who included an emerging market equity fund in their well-diversified asset allocation strategies have been rewarded, as many of the popular strategies have outpaced the S&P 500 index. However, despite similar names, what’s inside these funds can be very different.

The average emerging market mutual fund rose 18.1% in the first half, ahead of the 8.2% average gain for U.S. equity funds. However, the passively managed iShares Core MSCI Emerging Markets ETF (IEMG) was up an even more impressive 18.7%. Inclusive of the extra trading days thus far in July, IEMG was up 18.0%, ahead of the 17.7% for the emerging market mutual fund average.

Even among passively managed funds, there are differences in performance, often due to the underlying holdings.

For example, consider the Vanguard FTSE Emerging Markets Fund (VWO) and its mutual fund share class Vanguard Emerging Markets Stock Index Fund (VEMAX). Based on name alone, one might think the two Vanguard products offer the same investment opportunity as IEMG. In fact, all three boast an expense ratio of just 0.14%. But VWO was up “just” 14.4% and VEMAX 14.6% in 2017.

                       

Not All Emerging Market Funds Perform the Same

Source: CFRA’s MarketScope Advisor, July 7, 2017

 

A simple matter of tracking error? With passive funds, investors will often look to how well the product tracks its underlying index. But according to data on ETF.com, IEMG has a median tracking difference of 11 basis points, only slightly lower than the 17 basis points for VWO.

Tracking error does not seem to be the reason for the performance difference. Rather, CFRA strongly believes the 360-basis-point performance differential is the result of what’s inside these popular funds.

 

A Question Of Korea
There are three areas worth focusing on from an exposure perspective: South Korea, China A shares and U.S.-listed Chinese stocks. All of them are tied to decisions made by MSCI and FTSE Russell, the providers of indices that iShares and Vanguard have chosen as benchmarks.

Chinese equity exposure tends to be the focus with diversified emerging market equity funds, as it represents the largest country exposure, but South Korean stocks were 15% of IEMG’s assets at the end of June.

Multinational companies Samsung Electronics and Hyundai Motor are examples of firms based in South Korea, and IEMG holds both. To put South Korea market performance in perspective, the iShares MSCI South Korea ETF (EWY), which also holds these and other Korean stocks, was up 26% in 2017.

However, South Korea is considered a developed market by Vanguard’s index provider FTSE Russell. As such, the Vanguard FTSE Developed Markets ETF (VEA) has an approximate 5% weighting in South Korea, adding diversification to French, German and Japanese stocks. Yet VWO and VEMAX have no such exposure. The Vanguard products also have higher stakes than IEMG in India and Brazil.

Considering China
Shifting to China, both VWO and IEMG have more exposure to this emerging market than any other country. However, the types of stocks included are distinct.

MSCI announced in June it plans in 2018 to add an approximately 1% weighting of China A-shares to its emerging market indices. In contrast, VWO and the mutual fund share classes began to add exposure to China A shares in late 2015 through a transition FTSE index and completed the China A shares inclusion in September 2016.

Relative to MSCI, FTSE Russell was earlier to get comfortable with China A-shares that trade on the Shanghai and Shenzhen exchanges through regulated programs. These securities have historically been held by local Chinese investors and have limited liquidity.

 

Yet the absence of China A-share exposure has been a positive in 2017, as other Chinese-focused funds have performed better than the A-shares. For example, the iShares MSCI China ETF (MCHI) has climbed 25% in 2017, and the iShares MSCI China A ETF (CNYA) was up 15%.

Meanwhile, in November 2015, MSCI added Alibaba Group (BABA), JD.com (JD) and other Chinese companies that trade on U.S. stock exchanges to its emerging market indices. Such exposure has been fruitful in 2017, with BABA and JD each climbing more than 50%.

 

Exposure Differences Between iShares and Vanguard ETFs

  IEMG VWO
14 basis point expense ratio Yes Yes
South Korean exposure Yes No
China A-shares exposure Not yet Yes
US-listed Chinese stocks Yes No

Source: CFRA Research

 

Both IEMG and VWO earn a top ranking of Overweight from CFRA, though there are differences between them due to these holdings distinctions. IEMG earns a higher ranking input for the STARS recommendations of the underlying holdings, aided in part due to the buy recommendation (4-STARS) on Samsung Electronics.

Both ETFs have bullish technical trends and trade for a penny bid/ask spread. For investors using ETFs to diversify their U.S. equity exposure, either IEMG or VWO are worthy candidates. But there are important due diligence differences. 

At the time of writing, neither the author nor his firm held any of the securities mentioned. Todd Rosenbluth is director of ETF and mutual fund research at CFRA, an independent research firm that acquired S&P Global Market Intelligence's equity and fund business in October 2016. He can be reached at [email protected]. Follow him at @ToddCFRA.

 

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