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ETF Specialist

Are There Better Emerging-Markets ETF Choices?

We look beyond the market-cap-weighted giants in search of a better beta among this growing crop of exchange-traded funds.

Many investors are aware of the inherent drawbacks of exchange-traded funds that track cap-weighted emerging-markets-equity indexes. Funds such as  iShares MSCI Emerging Markets (EEM) and  Vanguard Emerging Markets (VWO) have large exposures to state-run firms and global macro-driven sectors such as technology, energy, and materials. As such, they don't offer meaningful exposure to those sectors that are most leveraged to local growth trends, such as consumer and industrial firms. While we have been fans of  WisdomTree Emerging Markets Equity Income (DEM) as an alternative to its cap-weighted cousins--in large part because its dividend-weighted approach has produced better risk-adjusted returns over the last five years--we previously highlighted that this fund may be in for a bumpier road ahead.

Among actively managed mutual funds in the category, three funds with a Morningstar Analyst Rating of Silver-- Oppenheimer Developing Markets (ODMAX),  Aberdeen Emerging Markets (ABEMX), and  Virtus Emerging Markets Opportunities (HEMZX)--have recently closed or will soon close to new investors. We tend to view such closures favorably, as a couple of years of strong inflows can make it difficult for active managers to effectively implement their strategies. So, in an environment where the biggest ETFs aren't necessarily offering the best exposure, our perennial favorite in the ETF space is looking a bit more risky, and some of the better actively managed mutual funds are turning away new investors, what are some other options for investors seeking exposure to emerging-markets stocks?

Smoother Sailing?
There has been a lot of interest in low-volatility strategies lately, driven in part by the 2008 financial crisis and its lingering fallout. There are currently two ETFs offering low-volatility emerging-markets equity exposure-- iShares MSCI Emerging Markets Minimum Volatility (EEMV) and PowerShares S&P Emerging Markets Low Volatility (EELV). As their names imply, these funds' indexes have exhibited lower volatility (with annualized standard deviations in the low 20% range) over the last five years relative to the MSCI Emerging Markets Index (28%). In 2008, EEMV's and EELV's benchmark indexes declined 42% and 34%, respectively, versus the MSCI Emerging Markets Index's 53% decline. Taking some of the sting out of market sell-offs may lead to improved returns, as investors may be less likely to sell during bear markets if these strategies' drawdowns are relatively smaller. Conversely, these strategies likely will underperform during strong bull markets. While it may be difficult to hang on to a cap-weighted index during large market declines, it may be equally difficult to sit tight in a low-volatility strategy when other funds are participating more fully in market rallies.

The idea that low-volatility strategies outperform over full market cycles would seem to upend the capital asset pricing model (CAPM) and the commonly held belief that that assuming greater amounts of risk will result in greater returns. In practice, low-volatility strategies historically have generated better risk-adjusted returns relative to their corresponding cap-weighted indexes over the long term. As such, these two funds could be suitable core holdings for an emerging-markets-stock allocation.

For investors interested in learning more about low-volatility strategies, we suggest reading "Making Sense of Low Volatility Investing," by Feifei Li of Research Affiliates. Li provides a well-written summary on the academic research, historical performance, and potential diversification effects of low-volatility strategies. Also worth a read is "The Low-Volatility Effect: A Comprehensive Look" by Aye M. Soe of S&P Dow Jones Indices. Soe's article covers similar ground and also examines the performance of low-volatility strategies in emerging markets.

In United States markets, the outperformance of low-volatility strategies can be partially attributed to the small-cap and value effect. This is not necessarily true in emerging markets--at this time, both EEMV and EELV have slight growth tilts. And while the average market cap of these funds' portfolios is about $10 billion versus about $20 billion for the MSCI Emerging Markets Index, this difference is partly due to the fact that the low-volatility portfolios have relatively less--if any--exposure to the government-controlled large caps that comprise a substantial portion of the MSCI Emerging Markets Index.

You Say Minimum Volatility, I Say Low Volatility
EEMV and EELV track different indexes and employ different methodologies, yet they have generated very similar historical returns. EEMV's index (MSCI EM Minimum Volatility Index) seeks to create a minimum variance (or lowest volatility) portfolio of 200 holdings culled from the MSCI Emerging Markets Index, using an estimated security covariance matrix and a number of constraints to limit turnover and to ensure investability and sector and country diversification. EEMV launched in October 2011, and over the trailing 12 months to Feb. 28, 2013, this fund's net asset value trailed its index (adjusted to reflect foreign withholding taxes on dividends) by only 20 basis points, which is less than the fund's 0.25% expense ratio. The portfolio is rebalanced twice a year, in May and November, and the turnover ratio over the last year was 31%. The one downside to this strategy is that the index methodology is not transparent.

Turning to EELV, this fund's index (S&P BMI Emerging Markets Low Volatility Index) seeks to create a low-volatility portfolio by employing a simple rule--it selects the 200 least-volatile stocks from the S&P Emerging BMI Plus LargeMidCap Index and weights each holding by the inverse of its volatility (the standard deviation of daily price returns over the trailing 252 days). This fund's benchmark employs the same methodology as the popular  PowerShares S&P 500 Low Volatility (SPLV).

Unlike EEMV's bogy, EELV's benchmark does not employ any sector- or country-level constraints. Over the last 12 years, the index generally has been underweight energy and technology names and overweight what are generally perceived to be steady sectors--utilities and consumer staples. During this time period, sector allocations have remained fairly steady, although constituent securities may not have been consistent. Country weightings, on the other hand, have been less steady and have strayed significantly from those of the MSCI Emerging Markets Index over the last 12 years. That said, the index typically has maintained very low weightings to stocks from China, Russia, and India. India and Russia likely will continue to be relatively underrepresented in this fund, as only the overseas listings of their securities are allowed in the index.

EELV's benchmark index is rebalanced at the end of each quarter. Last year the index had a turnover ratio of 50%. This fund, which was launched in January 2012, has not tracked its index as well as EEMV--over the trailing 12 months to Feb. 28, the fund's NAV performance trailed that of its benchmark by 70 basis points, greater than the fund's 0.29% expense ratio. At the end of last year, S&P added a liquidity screen to the index, which may make it easier for the fund to more effectively track the index. Given EEMV's better index tracking, significantly higher trading volume, and slightly lower expense ratio, we would recommend it over EELV.

Gaining Momentum
While there has been relatively little academic research done on momentum in emerging-markets stocks, it has been observed in this asset class. There is currently one ETF that looks to capitalize on momentum in emerging-markets stocks--PowerShares DWA Emerging Markets (PIE), which was launched in December 2007. Over the five year period ending Feb. 28, 2013, this fund's benchmark index produced annualized returns that outstripped the MSCI Emerging Markets Index by 155 basis points while exhibiting fairly similar levels of volatility. However, executing this high turnover strategy in emerging markets can be challenging, as evidenced by the fact that PIE has significantly trailed its index by almost 500 basis points on an annualized basis over the last five years. This can be partly explained by the fact that its benchmark index did not have any liquidity screens until 2012, and at times the fund would have difficulties tracking its index because it could not acquire certain illiquid small- and mid-cap index constituents. In 2012, the index introduced a liquidity screen and this may have contributed to the fund's improved tracking--PIE trailed its index by 77 basis points last year, which is even lower than the fund's 0.90% expense ratio. Risk-tolerant investors looking for more growth-oriented exposure to emerging markets may want to consider PIE; it is currently the only emerging-markets ETF of reasonable size to provide a growth tilt.

PIE tracks an index that selects 100 stocks using a measure of relative strength, or a stock's performance relative to a universe of about 1,000 stocks. Securities with better short-term relative strength characteristics are given relatively higher weightings, and the index is reconstituted quarterly. There are no country or sector constraints, so this fund's portfolio can look very different from the MSCI Emerging Markets Index. Since PIE's launch, its portfolio has generally had relatively higher weightings in Asian stocks and the industrials, consumer staples, consumer discretionary, and health-care sectors. Meanwhile, it has had relatively lower weightings in the energy, technology, and financials sectors. While this appears to provide better exposure to domestic growth trends in emerging markets (relative to those of a cap-weighted index) and have been somewhat steady over the last five years, sector weightings could change at the quarterly reconstitution as sectors move in and out of favor.

Patricia Oey will be a panelist for the "Smarter International Investing" session of the Morningstar Individual Investor Conference, which will take place on on Saturday, March 23. Details below.

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Patricia Oey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.