Emerging Markets' Steep Spiral Hits ETFs

Slowing economic growth, a stock market crash in China, plunging commodity prices and the threat of a Fed rate hike—these are the concerns that have plagued emerging markets recently and investors are starting to feel the pressure.

Exchange-traded funds tied to emerging markets have been barreling downward all month long, putting most of them deep in the red for the year. The $23 billion iShares MSCI Emerging Markets ETF (EEM | B-99) touched its lowest point in four years today and is now down 13.3 percent year-to-date.

The massive $49 billion Vanguard FTSE Emerging Markets ETF (VWO | B-87) has fared only slightly better, with an 11.6 percent loss.

YTD Returns For EEM, VWO

China Syndrome
For emerging market funds, China is the biggest holding, and thus, the biggest problem. The country makes up almost 19 percent of EEM's portfolio and 21 percent of VWO's portfolio.

By now, the issues facing China are well-known to most investors. Growth in the world's second-largest economy has been slowing significantly. GDP is expected to expand by only 7 percent or less this year, the slowest pace in 25 years.

Some analysts like Chad Morganlander, portfolio manager at Stifel Nicolaus, believe that China's real growth is as low as 4 to 5 percent. That view is echoed by a number of other analysts and economists who question the veracity of China's official growth figures.

While the data may be suspect, one thing that is certain is that the country faces significant challenges in its transition away from an export-orientated economy toward a consumption-driven one.

Falling Currency & Markets
Last week, the People's Bank of China stunned markets after it devalued the yuan to its lowest level since 2012. That fueled speculation that perhaps authorities were growing worried about the sharp slowdown in China's exports, which fell by 8.3 percent from a year ago in July.

Growth issues aside, China is also grappling with the highly publicized crash in its stock market. The Shanghai Stock Exchange Composite Index lost nearly a third of its value since June, which prompted the government to take drastic measures to stem its decline.

Though none of the broad-based emerging market ETFs holds mainland China A-shares yet (that's scheduled to change later this year), they've certainly been impacted by the simultaneous drop in other China share classes, such as those that trade on Hong Kong.

If China's stock market continues to crash, emerging market ETFs are likely to continue to struggle.

Not All About China

That said, emerging markets aren't all about China. After all, about 80 percent of the exposure in the big emerging market ETFs comes from elsewhere. For EEM, which tracks the MSCI Emerging Markets Index, South Korea has the second-largest weighting, at 14 percent.

For VWO, which follows an emerging market index from FTSE, India takes the No. 2 position, with a 13.5 percent weighting. In fact, VWO doesn't even hold South Korean stocks—the country isn't considered an emerging market by FTSE.

Altogether, Asia Pacific countries represent about 60 percent of EEM's portfolio, followed by 10 percent for Africa/Middle East, 9 percent for South/Central America, 8.7 percent for Central Asia, 7.2 percent for Eastern Europe and 5 percent for North America.

Source: Bloomberg

For VWO, it's 51 percent in Asia Pacific, 13.5 percent in Central Asia, 11 percent in Africa/Middle East, 10.5 percent in South/Central America, 8.5 percent in Eastern Europe and 5.5 percent in North America.

Source: Bloomberg

Commodity Bust Weighs

Unfortunately, diversification across regions has done little to stem the decline in these ETFs. While Asian countries reel from the slowdown in China, Africa and the Middle East face their own problems from the precipitous decline in commodity prices.

South Africa, which holds the largest weighting in the region by far, has felt the pinch from plunging prices for metals, particularly platinum and palladium. Meanwhile, Gulf energy producers like the UAE and Qatar have been slammed by the worst oil bust in decades.

The oil bust has, of course, spread beyond just the Middle East. Russia, the biggest emerging market in Eastern Europe, has an economy that is notoriously dependent on crude. The country's GDP contracted by 4.6 percent year-over-year in the second quarter of this year, largely due to the drop in oil and natural gas prices.

South America is another region hurt by the commodity slump. Brazil, the most notable market on the continent, is a leading producer of a multitude of commodities, essentially all of which have been plunging recently. From sugar to coffee to soybeans to iron ore, it's been an ugly year for Brazil's commodity industry.

Brazil's economy has also struggled with high inflation and a massive corruption scandal. If the U.S. Federal Reserve hikes interest rates later this year as many expect, that could push Brazil's inflation rate even higher, should the country's currency continue to depreciate. Earlier this month, the real hit a 12-year low against the dollar.

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].