Smart Beta Fuels Best Performing Emerging Market ETFs

October 24, 2016

Emerging market ETFs have made quite a comeback in 2016, rallying across the board as investors looked for value—and for a possible bottom—in the beaten-down segment.

But among total market funds, the best-performing emerging market ETF year-to-date isn't any of the most popular ones—funds like the iShares MSCI Emerging Markets ETF (EEM), the Vanguard FTSE Emerging Markets ETF (VWO) and the iShares Core MSCI Emerging Markets ETF (IEMG).

It's the PowerShares FTSE RAFI Emerging Markets Portfolio (PXH) that's delivering the strongest performance in 2016. The fund's year-to-date returns are roughly double the returns of key competing funds. Look at the chart below: 

 

 

PXH has "only" $620 million in assets under management—a far cry from the $44.3 billion in VWO, the $31.5 billion in EEM and the $17.6 billion in IEMG. So far this year, investors have poured nearly $5 billion of fresh net assets into VWO, while EEM and IEMG have seen combined net creations of almost $13 billion. PXH gathered $209 million in the same period.    

PXH Has Different Country Tilts

That's not entirely surprising, because PXH is a smart-beta take on emerging market equities. It deviates from the traditional market-cap-weighted approaches most investors are comfortable with. The fund offers a portfolio that's fundamentally weighted. It picks stocks based on cash flow, dividends, sales and book value, and then weights these stocks based on their fundamental scores. Those showing the highest fundamental strength get the biggest weighting.

The end result is a total market ETF that shows country tilts that are different from market-cap-weighted ETFs as well as different sector exposures.

This year, these tilts have worked to PXH's benefit in terms of returns. The fund allocates most heavily to Brazil—one of the best-performing emerging market this year—representing nearly 30% of the portfolio. Russia also ranks among PXH's top country allocations, at about 9%. Russia, too, has been a leader in performance among emerging markets.  

EEM & IEMG Overweight Asia

By comparison, EEM and IEMG lead country allocations with China, South Korea and Taiwan—markets that have risen in 2016, but not to the same extent as Brazil and Russia. In fact, in EEM and IEMG, Brazil and Russia represent a combined weighting of less than 12%—compare that with 39% for PXH.

For EEM and IEMG, both tracking market-cap-weighted MSCI indexes, country allocations are, in a way, a result of market capitalization. The underlying benchmarks look to capture more than 85% of the total emerging market investable universe, and these securities are ranked by market capitalization.  

To illustrate those individual country performances through an ETF lens, look at the year-to-date chart below plotting the following ETFs:

 

 

PXH, like VWO, also classifies South Korea as a developed market, while EEM and IEMG consider it an emerging market, and one that ranks fairly highly in both portfolios, at No. 2, with about a 14% weighting. South Korea, as measured by the performance of the iShares MSCI South Korea ETF (EWY), is up about 13% year-to-date.

These differences in portfolio allocations are an important driver of returns in emerging market ETFs.

 

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