Shining Spots In Emerging Market ETFs

It all started so well. Coming into 2019, emerging markets as a region was cheaply valued at multiyear lows, offering a perfect jumping point for a strong and steady recovery rally hinged on the region’s promising growth story.

And rally it did until about mid-April. Some of the largest emerging market ETFs—the iShares Core MSCI Emerging Markets ETF (IEMG), the Vanguard FTSE Emerging Markets ETF (VWO) and the iShares MSCI Emerging Markets ETF (EEM)—were up 13-14% in the first 3½ months of the year. Their performance was a solid showing, considering the S&P 500 was up about 16% in that time frame, measured here by the SPDR S&P 500 ETF Trust (SPY):

What happened next changed it all: A trade war took hold. First with China, then with Mexico, then back some more with China; months later, we are still watching a trade dispute of global significance unfold. And one that’s taking place as investors fret about a slowing global economy.

China has dealt with a lot this year, from the ongoing trade war with the U.S., to internal battles with Hong Kong, to slowing domestic growth. China is the world’s second-largest economy, it’s also the biggest emerging market, representing at least a third of broad emerging market ETFs such as EEM, IEMG and VWO.

If China hurts, so does the rest of the emerging market space. Year to date, these ETFs have given up much of their earlier-year gains:

It’s not surprising to see that investor demand for exposure to emerging markets all but dried up halfway through the year.

Emerging market ETFs have now seen seven consecutive weeks of outflows totaling $12 billion in redemptions in that period. Some of the bigger funds are still in the black, but barely. 

Broad, Cheap Beta At The Top

Leading net inflows year to date are the broadest, cheapest total emerging market equity ETFs, as seen in the table below:

Source: ETF.com/FactSet

While those top three funds—IEMG, VWO, SCHE—have China representing a big cut of the portfolio, they are also the cheapest funds in the space, offering investors broad, accessible diversification for a very low cost in a single wrapper.

If you are a long-term, buy-and-hold investor with a broadly diversified asset allocation, chances are one of these funds is part of your mix. So, their assets tend to be sticky.

Standout: EEM Bleeds

Note that EEM isn’t among the year’s top 10 creations in this segment. The fund has actually seen net outflows year to date of nearly $5.5 billion.

Not only is EEM a lot pricier than its peers, with an expense ratio of 0.67%—making it a poor choice for cost-conscious investors—it’s also vastly more liquid. That makes EEM a favorite among day traders. EEM trades $2.4 billion on average every day at spreads averaging 0.02%—that’s more than three times the daily volume of IEMG and six times the average volume of VWO. But it’s still losing assets.

No One Chasing Performance

What’s interesting in emerging market ETFs this year is that investors are clearly spooked about the risk. Outside of broad diversification goals, demand has focused on safety and income rather than performance chasing.

Consider that the top-performing emerging market ETF is the Global X MSCI China Consumer Staples ETF (CHIS), with gains of nearly 40% year to date. CHIS has done so well it currently ranks among the top 10 best performers of the entire ETF market—2,600 or so funds.

The top seven best-performing emerging market ETFs this year are all China-linked, with gains ranging from 22% to 38%, including funds like the CSOP FTSE China A50 ETF (AFTY), the Global X MSCI China Health Care ETF (CHIH) and the Xtrackers Harvest CSI 300 China A-Shares ETF (ASHR).

Yet none of these funds has seen any significant flows, most of them with net zero action. Performance has been great, but investor sentiment clearly has not.

Outside of single-country funds, top performance has been seen in the Emerging Markets Internet & Ecommerce ETF (EMQQ) and the KraneShares Emerging Markets Consumer Technology Index ETF (KEMQ) this year.

These funds have outperformed the broader segment as measured by EEM significantly this year:

Again, no assets have followed these gains. EMQQ has attracted only $7 million in net creations this year, while KEMQ has actually bled $5.5 million in net redemptions.

Safety & Yield In Local Bonds

Emerging market bonds have also felt the pinch of overall weakness in emerging markets, but there’s been some demand for local-currency bond ETFs. The VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (EMLC) is among the year’s top 10 creations in this segment.

Why? Probably because local bonds are offering some impressive yields, especially in the face of severely compressed yields in the developed world. EMLC, which has about $5 billion in total assets and holds nearly 300 sovereign bonds with 10 years or less duration, offers a 30-day yield of 6.3%. For comparison, the 30-day yield on the iShares 7-10 Year Treasury Bond ETF (IEF) is 1.9%.

Also supporting this space is the fact that emerging market currency valuations are still well below historical averages. Low valuations make these local-currency bonds that much more attractive in the face of a strong dollar. Investors have taken notice.

Appetite For A Low Vol Ride

Finally, another interesting fund to pop up among the year’s top 10 EM flows is the iShares Edge MSCI Min Vol Emerging Markets ETF (EEMV).

This minimum volatility portfolio hasn’t outperformed the broader universe as measured by EEM this year. On the contrary, EEMV is now slightly underperforming, as the chart below shows:

Charts courtesy of StockCharts.com

Demand here has not been linked to total returns, but rather to the path of returns—lower vol returns. It speaks to investor aversion to risk in emerging markets this year, and as a result, EEMV has pulled in more than $360 million.

In the month of August, for example, as EEM dropped 5% in a matter of days, EEMV dropped only 2.5%. The fund, which picks and weights securities based on volatility, has beta of 0.6, meaning it should offer investors a ride that’s about 40% less volatile than the broader market.

Truth be told, emerging markets are a volatile asset class in nature—there’s no escaping that investing in the region is risky. Look no further than the recent one-day drop of 40% in the Argentinian stock market—a plunge so steep, it’s one for the history books—to be reminded of the volatility inherent to this space.

But EEMV can soften that wild ride, and it has done that in a year when investors have been spooked. It’s no surprise to see demand for this low vol strategy materialize.

Contact Cinthia Murphy at [email protected]