Emerging Market Window Still Wide Open

November 07, 2017

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Rusty Vanneman, chief investment officer of Omaha, Nebraska-based CLS Investments.

Emerging market (EM) equities are having a great year. As of Oct. 13, the MSCI Emerging Market Index is up 33%. These returns are prompting more investors to get interested in emerging markets, but is already it too late for ETF investors?

Relative Valuations

At CLS, we believe emerging market stocks are still attractive, as they remain relatively cheap. For instance, the chart below examines a combination of valuation metrics (price-to-sales, price-to-book, price-to-cash flow and price-to-earnings) since 2001, and shows that emerging markets on average (represented by the red line) trade at a 15% discount to the overall world stock market. In other words, emerging market equities are typically inexpensive. 

 

 

Currently, even though emerging markets have had an incredible run, they remain undervalued, and are trading at a 23% discount. In other words, despite the recent markup in prices, they are still on sale.

Technicals

When would we consider selling emerging markets? First, we would need to see them trading at a premium to their long-term relative valuation averages on the chart above. Once that happens, we would need to see emerging markets start to break down from a technical perspective (technical analysis in this case focuses only on prices and does not consider fundamental inputs, such as revenues or earnings).

For the latter, let’s review a broad-based emerging market ETF (the iShares Core MSCI Emerging Markets ETF (IEMG)) using relative performance versus the MSCI World Index (as of Oct. 17, 2017):

 

 

This chart includes five indications we find technically attractive:

  1. The current price (blue line) is above the quarterly (63 days) moving average (purple dotted line). That’s bullish.
  2. The current price is above the annual (252 days) moving average (green line). That’s also bullish.
  3. The quarterly moving average is above the annual moving average. That’s bullish, too.
  4. Current prices are above levels from one year ago. Again, bullish.
  5. Another typically positive indicator is prices falling below where they were three years ago. In this case, prices are about even. This is not a negative.

In total, the technical condition of emerging markets is still strong.

Sentiment

Another aspect of technical analysis is investor sentiment—what investors are saying and doing with their investment dollars. U.S. investors and global money managers still remain well underweight to emerging markets. CLS Portfolio Manager Kostya Etus, CFA, reviewed current fund allocations (ETFs and mutual funds), and found allocations remain below benchmark weights.

For instance, managers in the world stock category remain 3% below the benchmark weight for emerging markets in the MSCI ACWI Index. World allocations are still more than 1% underweight. Mutual fund investors, in general, have only 3% in emerging market equities.

Emerging Market ETFs

ETFs are an excellent vehicle with which to get exposure to emerging markets. When investing in ETFs, an investor gains a diversified portfolio with professional oversight at a reasonable cost.

At CLS, we use both broad-based and granular ETFs, depending on what type of portfolio we’re managing and current market opportunities. For instance, some strategies we manage might only contain a handful of names. In that case, we will most likely use a broad exposure.

In other strategies, where there is no limit on names held, we can get much more granular in the types of ETFs we will own. Again, it depends on the opportunities present in the marketplace.

Here are some ETFs we currently use: 

 

Ticker Fund Name Market Exposure
PXH PowerShares FTSE RAFI EM Smart Beta - Value
EDIV SPDR S&P Emerging Markets Dividends Smart Beta - Dividend
IEMG iShares Core MSCI Emerging Markets Core - broad-based
VWO Vanguard FTSE Emerging Markets Core - broad-based
GXC SPDR S&P China Chinese equities
FNDE Schwab Fundamental Emerging Markets Large Company Smart Beta - Value
GEM Goldman Sachs ActiveBeta Emerging Markets Smart Beta - Multifactor

 

Bottom line: Emerging markets are indeed having a great year, but for long-term investors, it appears the train has only just left the station.

At the time of writing, CLS Investments invests in all of the securities mentioned above for its clients. CLS Investments is a third-party investment manager and ETF strategist. It began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds. Contact CLS’ Chief Investment Officer, Rusty Vanneman at 402-896-7641 or at rusty.vanneman@clsinvest.com. Please click here for a complete list of relevant disclosures and definitions.3174-CLS-11/2/2017

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