ETFs Capturing Emerging Market Gains

July 15, 2020

Investors love a winning market segment, and emerging markets—perhaps surprisingly—suddenly fit that bill, not that anyone has cared too much about it.

Since the U.S. stock market hit a low on March 23, broad emerging market ETFs have picked up momentum, retracing oversold conditions and rising to new highs. The iShares Core MSCI Emerging Markets ETF (IEMG) and the Vanguard FTSE Emerging Markets ETF (VWO) have now matched the massive run-up of the S&P 500 ETF Trust (SPY) in that time window:

 

 

Asset Creations Lagging
U.S. investors, however, have not really bought into this ride. Some have even called this the most under-owned and unloved rally we’ve seen in recent times.  

IEMG has bled more than $4.3 billion in net redemptions since March 23; VWO has lost about $3.2 billion in net outflows; and the iShares MSCI Emerging Markets ETF (EEM) has seen some $630 million in net redemptions.

History Not Your Friend
The skepticism over whether this latest bout of strength has any legs isn’t surprising given recent history.

“Over the last 10 years through the end of March, the MSCI Emerging Market Index barely squeezed out a 0.68% annual return versus the S&P 500, which returned nearly 11% a year,” Ben Doty, senior investment director at Koss Olinger, said.

Sliced another way, going back to the March 2009 financial crisis low to earlier this month, SPY rallied almost 490%, while the MSCI EM Index was up less than 200%, KraneShares’ CEO Brendan Ahern notes.

“That enormous disconnect is due to close at some point,” Doty said, arguing the recent run-up is partly fueled by relative value in the space.

But Ahern offered the sobering reminder that, “if you look historically, the more diversified away from the U.S. you’ve been, the more you’ve underperformed.” It’s no wonder investors continue to have really strong home bias, and really strong skepticism toward emerging markets.

2 Key Winning Trends
That said, this recent uptick in EM performance highlights two interesting trends in this space:

  1. Country exposure has made all the difference. China (and more broadly, Asia) is largely leading this move higher.
  2. Sectors have mattered more than ever. It’s high-growth names—mostly in technology—that have pushed performance higher.

It makes sense, then, that broad EM ETFs are lagging—and bleeding assets—relative to some narrower strategies accessing some of these leading pockets of performance.

What To Consider: Asia
China is the best-performing stock market globally this year, despite COVID, trade tensions and domestic disputes with Hong Kong. Other Asian economies, including Taiwan, Malaysia and South Korea, are also among top performers.

“The bigger story lies in Asia,” Forstrong CIO Tyler Mordy explained. “Consider all the positives: Asia’s handling of this year’s health crisis has been far better than any other region in the world. Asia’s fiscal and monetary policy response has been reasonable relative to the bazooka most Western countries pulled out to combat the crisis—there’s still spare ammo and plenty of room for policy easing.

“And Asian stock markets do sport much lower valuations than their developed counterparts,” he added.

What’s more, low oil prices and a weakening U.S. dollar are also beneficial for many Asian economies, which are big commodity importers, he adds.

“Of course, Asian companies remain vulnerable to a fragile global growth environment,” Mordy said. “However, it would not be the first time that the above confluence of conditions created a lasting bull market in Asian stocks. We fully expect this time will not be different.”

China-focused equity ETFs—funds such as the Xtrackers Harvest CSI 300 China A-Shares ETF (ASHR), the iShares MSCI China ETF (MCHI) and the KraneShares Bosera MSCI China A Share ETF (KBA)—have outperformed broader strategies (like EEM) as well as SPY year to date:

 

 

There are 48 ETFs in the market focused on China, and a number of single-country funds accessing different Asian nations. China and Asia also feature prominently in broader market strategies:

  • IEMG is 36% allocated to China/Hong Kong, at least 65% tied to Asia (12% to South Korea, which is a big differentiator to VWO).
  • VWO, too, has about 65% in Asia, but a bigger allocation to China (42%), Thailand and Malaysia, as it excludes South Korea.

But If China Worries You …
These days there’s a lot of concern centered on China. Whether you doubt the accuracy of China’s economic data, or worry about the country’s governance and ongoing trade disputes, there are ways to capture this Asia-centered rally by excluding China.

“China is always the elephant in the EM room, because it’s approximately 40% of most EM ETFs,” Life & Liberty Indexes founder Perth Tolle said. “In China, all companies, public and private, can be used as tools anytime for social control at the whim of the state. Information is not transparent or reliable, and prices don’t reflect economic value; they reflect speculation driven by state signals.

“Now, China’s government is pumping up their market again,” Tolle said. “Investors should be aware of the heightened risks in an artificially run-up market dominated by speculators responding to the signals of a fragile state. In any market, people are the engines of growth.”

 

 

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