Emerging markets are back in vogue. ETFs targeting the segment are up significantly more than their developed-market counterparts this year after underperforming the past four years.
The two largest emerging market ETFs—the iShares MSCI Emerging Markets ETF (EEM) and the iShares Core MSCI Emerging Markets ETF (IEMG), both with around $30 billion in assets—are up just shy of 17% on a year-to-date basis, easily outpacing the 7.8% gain for the SPDR S&P 500 ETF (SPY).
That's a surprising result for a year in which many analysts had predicted continued underperformance in emerging markets due to Trump's trade policies and a rising U.S. dollar. The president's policies haven't proven to be as detrimental to trade as initially feared, and the greenback is actually down 2.5% on the year, providing some relief for battered emerging market equities.
Better Than US Stocks
A stabilization in commodity markets, which are a key income source for many emerging markets, also aided the group. This improved backdrop may mean that corporate earnings for emerging markets accelerate by 26% in 2017, according to Geoffrey Dennis, head of Global Emerging Market Strategy at UBS Investment Bank. That compares to an expected 10% growth rate for U.S. corporations.
Even after the rally, widely followed investor Jeffrey Gundlach said that emerging market stocks are still a better buy than U.S. stocks, so much so that he would recommend going short SPY, while going long EEM.
"The valuation of emerging markets is half the valuation of the S&P 500 when you look at things like price-to-sales, price-to-book and Dr. Shiller's CAPE ratio," Gundlach told CNBC on the sidelines of the Sohn Conference.
Riding The Trend
The long-EEM/short-SPY pair trade is one way to express a bullish view on emerging markets. Another way—and the most common—is simply to buy one of the broad emerging market ETF like EEM, IEMG or the Vanguard FTSE Emerging Markets ETF (VWO) and call it a day.
But for investors who want to make an even more aggressive bet on the rising emerging market trend, there are more focused ETFs available that have the potential for greater gains (and greater losses).
Nine of the 10 best-performing emerging market ETFs so far this year target a single country. The only exception is the Emerging Markets Internet & Ecommerce ETF (EMQQ), up 37.4%. EMQQ holds stocks of more than 40 internet-related companies operating in almost 20 different countries.
The other top-performing EM funds hone in on one of four countries.
The biggest emerging market winner so far this year is India, with four of the top 10 emerging market ETFs holding India equities. Those include the VanEck Vectors India Small-Cap ETF (SCIF), up 44.4%; the Columbia India Small Cap ETF (SCIN), up 43%; the iShares MSCI India Small Cap ETF (SMIN), up 39.2%; and the Columbia India Infrastructure ETF (INXX), up 32.3%.
India has long been a darling of many emerging market investors due to its favorable demographics and business-friendly Prime Minister, Narendra Modi.
According to a report by Gaurav Sinha, asset allocation strategist at WisdomTree, India is the only large economy growing by 7% or more: "In 2016, India not only surpassed China in terms of GDP acceleration, but it’s expected to grow at 7-7.5% for the foreseeable future."
"We expect the Modi government to implement more reforms in 2017 and 2018 that will continue to make India an attractive destination for investment," Gaurav added in his report.
UBS' Dennis also has a bullish view on India, but he noted in an interview with ETF.com that the forward P/E for the country is 17.9, which is pricey compared with forward P/E of 12 for emerging markets as a whole.
After India, Brazil makes the greatest number of appearances in the top 10, with two ETFs making the cut. The VanEck Vectors Brazil Small-Cap ETF (BRF) and the iShares MSCI Brazil Small-Cap ETF (EWZS) gained about 34% each on a year-to-date basis.
After suffering through its worst recession in history in 2016, hopes are that Brazil's economy will start to grow again this year. In April, the Central Bank of Brazil slashed interest rates by 1%, the largest decrease since 2009, and analysts expect the central bank to continue cutting rates aggressively this year in an effort to stimulate the economy.
Reforms by Brazil’s President Michel Temer—particularly when it comes to pension benefits—may also give a boost to an economy that's struggled with record budget deficits for the federal government.
“Fundamentals look bad now, but a year from now, fundamentals will look better, and the stocks are going to go up and everyone is going to want to own them,” Will Pruett, portfolio manager at Fidelity, recently told Bloomberg. “It’s clear that we’re through the cycle, which is the big thing.”
China, which was at the epicenter of last year's emerging market woes, has been a mixed bag this year. The only China ETF to make the top 10 is the KraneShares CSI China Internet ETF (KWEB), with a 35.5% gain for the year. KWEB primarily holds stocks of U.S.-listed Chinese software and IT services companies.
Some China ETFs, like KWEB, have done better than the broader emerging market indices, while some have done worse. In general, China A-shares―those that trade on the mainland―have significantly underperformed China H-shares (traded in Hong Kong) and N-shares, which trade overseas.
A Chinese government crackdown on the country's financial sector is weighing on mainland shares, while earnings growth boosts shares outside the country, say analysts.
“These investors don’t believe that any of this will lead to a crisis,” said Caroline Yu Maurer, head of Greater China equities at BNP Paribas Investment Partners, told Bloomberg. “For stocks, people are buying earnings growth rather than macro stories. The market is quite resilient as long as that holds.”
"The European economies are doing better, and Poland is a direct beneficiary of that, as the country does a lot of trade with Germany," said UBS' Dennis. "You also have the fact that the market was unloved for so long, so it became very inexpensive.
Dennis pointed out that from the end of 2006 to the end of 2016, Poland underperformed the broader emerging market space in eight out of 10 years, losing 57% compared to only 5.5%.
Top-Performing Emerging Markets (YTD 2017)
Note: Data measures the year-to-date period through May 10
Contact Sumit Roy at [email protected]