Don’t Give Up On Emerging Market ETFs

Broad emerging market ETFs have faced a steep correction in recent weeks, triggered largely by the outcome of the U.S. presidential election last month and the ongoing strengthening of the dollar.

In its totality, it looks like 2016 will close with funds like the iShares MSCI Emerging Markets ETF (EEM) and the Vanguard FTSE Emerging Markets ETF (VWO) comfortably in the black despite the recent plunge, just not as much in the black as investors might have expected following an earlier-year performance that suggested emerging market ETFs were finally rising from multiyear lows.

The chart below shows how these ETFs have done relative to the S&P 500: 

Looking ahead, however, it seems the temporary setback in emerging market ETFs could prove to be just that: temporary.

What Market Experts Say

Consider, for instance, Mark Dow’s views—founder of Dow Global Advisors in Laguna Beach, California, and someone with 20 years of experience as a policymaker, investor and trader focused on global macro and emerging markets.

Dow had been calling for the formation of a bottom in emerging markets all year, arguing that currencies had gotten stretched on the downside, and saying that investors should brace for up and down action until the emerging market fundamentals start to get better. According to him, that improvement would come as a result of clearer U.S. dollar and U.S. interest rate policies, as well as resurgence of growth in the region.

Today he is still a believer in the ongoing bottoming process despite the correction, and in the growing opportunity in the space.

‘Still Look Vulnerable’

“I am still working with the ‘L’-shaped recovery for emerging markets,” Dow said. “In the very near term, they still look vulnerable to more downside. But I’m thinking next month or two will likely give us a good tactical moment to buy EM equities.”

Another investment manager in this camp is Rusty Vanneman, chief investment officer of Omaha, Nebraska-based CLS Investments. He sees the region as a good value play, and one that should perform well going forward.

“The primary reason to invest in EM remains intact: Valuations are far more attractive than they are in the developed markets, especially the U.S.,” Vanneman said. “EM has lagged significantly over the last five-plus years, and their valuations—and thus their expected returns—are now far better. The markets move in cycles.”

“The common narrative is that a stronger dollar is not a positive for EM, and that does appear to be the case in recent weeks, but a stronger dollar has been on the view that U.S. interest rates will rise,” he added. “Historically, at least back to the 1970s, EM equities are one of the strongest-performing asset classes when interest rates are rising.”

Different Plays

Investors have different ways to tap into this emerging market story. Dow, for one, says that buying EM equities right now may be premature, particularly because the region still lacks growth. But local currency sovereign bonds look attractive to him.

According to him, these bonds are shelling out “a really nice yield” and if the downside in local currencies is limited, chances are they aren’t going to depreciate more than the yield these bonds are shelling out.

Some ETFs in this segment include:

• VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (EMLC), with $2.3 billion in AUM. The fund costs 0.47% in expense ratio and has a current 30-day yield of 6%.
• iShares Emerging Markets Local Currency Bond ETF (LEMB), with $288 million in AUM. It costs 0.50% in ER and has a 30-day yield of 4.99%.
• SPDR Bloomberg Barclays Emerging Markets Local Bond ETF (EBND), with $115 million in AUM. It costs 0.50% in ER and has a 30-day yield of 5.47%.
• First Trust Emerging Markets Local Currency Bond ETF (FEMB), with $18 million in AUM. It costs 0.85% in ER and has a 30-day yield of 5.3%.

Here’s how these funds have performed in 2016: 

For equity investors, choices abound between broad emerging market portfolios, BRIC-focused (Brazil, Russia, India, China) plays or even single-country ETFs.

To Vanneman, a broader basket is a better way to go, although he notes BRICs are attractive.

“In general, I tend to prefer the broader approach, but the BRIC ETFs do have better expected returns at present,” he said. “While there is strong overlap in the top holdings, there are differences in sectors, regional exposures and market-cap breakdown. On balance, the BRIC ETFs have become more attractive, including due to greater emphasis on emerging Asia and Latin America.”

Some of the largest broad market EM ETFs and BRIC total market ETFs include:

• iShares MSCI Emerging Markets ETF (EEM), with $26 billion in AUM. It costs 0.69% in ER.
• Vanguard FTSE Emerging Markets ETF (VWO), with $43.3 billion in AUM. It costs 0.15%.
• iShares Core MSCI Emerging Markets ETF (IEMG), with $17.4 billion in AUM. It costs 0.14%.
• Schwab Emerging Markets Equity ETF (SCHE), with $2.2 billion in AUM. It costs 0.13%.
•  iShares MSCI BRIC ETF (BKF), with $150 million in assets. It costs 0.69%. 

Charts courtesy of StockCharts.com

Contact Cinthia Murphy at [email protected]