New Emerging Market ETF Outperforms

The Legg Mason Emerging Markets Diversified Core ETF (EDBI) is still new to market, and a very, very small fund, with only $7 million in assets.

But so far this year, the almost-four-month-old ETF is delivering a performance that is leaving well-established emerging market funds such as the iShares MSCI Emerging Markets (EEM | B-100) and the Vanguard FTSE Emerging Markets (VWO | B-97) in the dust.

Look at the year-to-date chart below. EDBI is ahead by roughly 4 percentage points, with gains exceeding 12% in 2016:

Like its competitors, EDBI also tracks an index of emerging market stocks across the market-cap spectrum. Its index, in fact, tracks the same stocks as the broad MSCI Emerging Markets Index underlying EEM.

Fund Structure Is The Difference

But the fund is structured very differently. The methodology is designed around risk diversification and looks at countries and sectors as drivers of performance.

In EDBI, stocks are grouped into cap-weighted categories by sector and country, which are then evaluated for correlation to each other. Highly correlated country/sector categories are grouped into equal-weighted clusters.

The clustering process “looks at market risks through correlations”—it says that, say, commodity-sensitive economies such as Brazil and Russia behave similarly in a portfolio, QS Investor’s Mike LaBella, portfolio manager and subadvisor for Legg Mason’s ETFs, told ETF.com recently.

Reducing Concentration

Each cluster then receives equal weight in the index, and the theory is that, by holding equal exposure to clusters with low correlation to each other, the portfolio should see lower risk and avoid the concentration on highly correlated stocks often seen in other ETFs.

“This approach tries to take that macro exposure and diversify it, because cap-weighted indices can be very concentrated,” LaBella said.

“If you look at what's going on in emerging markets, BRICs [Brazil, Russia, India, China] dominate exposure. Investors are missing out on all these other opportunities,” he added. “So the strategy tries to identify relationships between those countries and sectors, and diversify that risk.”

In practice, this approach currently means a portfolio holds Hong-Kong-listed stocks as its top country allocation—China at about 13% of the mix. Malaysia, India, Turkey and South Africa follow, with anywhere from 9.8% to 6.6% weightings (as seen in table below).

EBDI Country and Sector Breakdown

Source: Legg Mason

From a sector perspective, about 15% of the 501-holding portfolio is tied to financials. Consumer staples, materials and consumer discretionary also rank highly, at more than 12% each.

By comparison, EEM is much more heavily allocated to China, with a 23% allocation, and South Korea and Taiwan round up its top three country exposures. Here, Malaysia and Turkey—some of EDBI’s biggest weightings—are much smaller allocations, as the table below shows.

EEM Country and Sector Breakdown

Source: iShares Website

Sector exposures are also vastly different. Information technology weighs heavily in EEM, but in EDBI is the smallest sector allocation.

Stark Example OF Underlying Differences

And then there’s VWO, an emerging market fund that doesn’t consider South Korea an emerging market. South Korea is EEM’s second-largest country allocation, and EDBI’s sixth-largest. That core difference in view suffices to exemplify how differently total-market emerging market ETFs are built.

These differences are the key drivers behind EDBI’s leading performance so far this year. Another important factor here is price. EDBI has a relatively cheaper price compared to EEM. Lower costs mean better total return per investment over time.

Of course, the winning fund among the three when it comes to cost is VWO, with total costs about $15 per $10,000. The ETF has gathered nearly $37 billion in assets, making it the No. 1 choice for investor in this segment.

But with an expense ratio of 0.50%, and an average trading spread of 0.12%, EDBI costs investors about $62 per $10,000 invested—that’s less than the $26 billion EEM, which costs 0.69% in expense ratio, and trades with an average 0.03% spread. Total costs for EEM hover around $72 per $10,000 invested.

EDBI is young—it came to market on Dec. 29, 2015—and it’s still very small, with less than $10 million in assets. But its performance is rivaling that of the greats in the space, and time will tell if investors will flock to it.

Contact Cinthia Murphy at [email protected].