Emerging Markets' Steep Spiral Hits ETFs

August 21, 2015

Vicious Spiral

As Brazil and other emerging market economies slow, capital outflows may pick up from their already-torrid pace. According to NN Investment Partners, outflows from the major emerging market countries totaled $940.2 billion in the past 13 months, a trend it expects to continue.

"More repatriation of U.S. capital and capital flight from the struggling emerging world to the U.S. dollar should be expected in the coming years," said the firm in a recent report.

As capital flows out of emerging markets, their currencies may continue to depreciate, pushing commodity demand down, fueling lower growth and more capital outflows―a vicious cycle.

There are other repercussions to consider as well. As emerging market currencies weaken, their foreign-currency debt burdens become more onerous. According to a Bloomberg report, developing countries have accumulated $2 trillion in dollar-denominated debt during the past several years, which they may find increasingly difficult to pay back.

Alternative Exposure

Given the challenges facing emerging markets, further losses may be in store. But at some point, they may begin to look attractive to long-term investors. Which ETF should you buy?

Vanguard's VWO is a good, cheap option for broad exposure with a mere 0.15 percent expense ratio.

On the other hand, EEM is relatively expensive, with an annual cost of 0.68 percent. Its sister fund, the iShares Core MSCI Emerging Markets ETF (IEMG | A-99), is the better buy, with an 0.18 percent expense ratio, and more comprehensive coverage, including small-caps.

Meanwhile, two notable "smart beta" emerging market funds offer modified exposure to the space. For investors wanting to avoid exposure to emerging market currencies, the iShares Currency Hedged MSCI Emerging Markets ETF (HEEM | D-52) provides that. HEEM has outperformed this year, only losing 9.1 percent, but the fund is relatively pricey, with a 0.71 percent expense ratio.

Finally, the iShares MSCI Emerging Markets Minimum Volatility ETF (EEMV | B-63) holds lower-volatility emerging market stocks in an attempt to reduce the risk of the portfolio. This year, the strategy has worked, as the fund fell 9.2 percent—less than the broad, market-cap-weighted ETFs. EEMV has an expense ratio of 0.25 percent.

Contact Sumit Roy at [email protected].

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