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ETF Specialist

An Emerging-Markets Trifecta

This ETF provides broad and low-cost exposure to an attractively valued market.

IShares Core MSCI Emerging Markets (IEMG) offers broad exposure to large-, mid-, and small-cap companies across 23 emerging markets, including Taiwan and South Korea. Its rock-bottom fee and inclusion of small-cap companies set it apart from its peers in the diversified emerging-markets Morningstar Category. Its market-cap-weighting approach promotes low turnover but also creates significant exposure to individual country risk.

Despite the inclusion of 23 emerging markets, China (26%), South Korea (15%), and Taiwan (13%) jointly account for more than half of the portfolio, owing to their large relative size. The same three countries make up less than 40% of the typical actively managed fund in the category. MSCI, the firm behind the fund's index, is also considering adding China A-Shares, which would further increase the fund's allocation to Chinese stocks.

The fund's broad portfolio effectively diversifies company-specific risk. The top 10 holdings account for less than 20% of the portfolio, compared with 30% for the average category peer. These include Samsung Electronics (SSNLF),  Alibaba Group (BABA), and several Chinese banks. Small-cap companies account for a small sliver of the portfolio, which adds a modest diversification benefit. They tend to be more highly leveraged to their local markets than their larger counterparts.

From its inception in October 2012 through August 2016, the fund underperformed the category average by 26 basis points annualized, but its sizable cost advantage should give it an edge over the long term. During the trailing 10-year period through August 2016, using the fund's benchmark (MSCI Emerging Markets Investable Market Index) less its 0.16% fee as a proxy, it would have outpaced the category average by 60 basis points annualized, besting nearly two thirds of its category peers with similar volatility.

Like most of its peers, this fund does not hedge its currency risk, which can hurt performance when the U.S. dollar strengthens relative to foreign currency and tends to increase volatility. During the trailing 10-year period through August 2016, nearly one fifth of the fund's total volatility came from currency fluctuations.

Fundamental View
Strong economic growth forecasts are often cited as a rationale for investing in emerging markets, but such growth has not translated into superior stock performance historically for several reasons. First, many of the larger firms listed in emerging markets generate a significant portion of their revenue and income abroad. This means that their profits can grow at a different rate than the domestic economy. Second, publicly traded companies often grow at a slower rate than their local economies because privately held companies drive a lot of that growth. Additionally, poor corporate governance in some emerging markets can lead to dilution of corporate earnings through new stock issuance.

Valuations also matter. From 2001 to 2010, emerging markets handily outperformed developed markets. At the beginning of this period, emerging-markets valuations were below their historical average following several financial and political crises, while the valuations in the U.S. stock market were high following the historic 1990s bull market. Recently, emerging-markets valuations have lowered relative to developed markets. During the trailing 10-year period through August 2016, the average difference in trailing 12-month P/E ratios for the MSCI World Index relative to the MSCI Emerging Markets Index was 2.7, showing emerging markets tend to trade at a lower valuation than developed markets. At the end of August 2016, the difference was 5.0, indicating emerging-markets valuations relative to developed markets are currently lower than their trailing 10-year average.

This fund offers a good way to get exposure to emerging-markets stocks. Its market-cap-weighting approach promotes low turnover and skews the portfolio toward large multinational firms. These companies tend to be more profitable and less volatile than their smaller counterparts. However, some of the fund's largest holdings are state-owned enterprises, which may be forced to prioritize political objectives over profit maximization. The fund's sector weightings are similar to the category average, but the fund has greater exposure to technology and less exposure to consumer defensive companies. Financial services and technology are the two largest sectors; each represent a little more than one fifth of the portfolio.

Emerging-markets stocks consistently exhibit higher volatility than stocks listed in developed markets. For example, during the trailing 10-year period through August 2016, the MSCI Emerging Markets Index's volatility has been roughly 20% and 35% greater compared with the MSCI EAFE Index (foreign developed markets) and S&P 500, respectively.

Despite this risk, emerging-markets stocks can provide significant diversification benefits. During the trailing 10-year period through August 2016, the MSCI Emerging Markets Index and S&P 500 were only 0.79 correlated. During the same period, the correlation between the MSCI Emerging Markets Index and MSCI EAFE Index, which tracks stocks listed in foreign developed markets, was 0.88.

Portfolio Construction
The fund employs a sampling approach to track the market-cap-weighted MSCI Emerging Markets Investable Market Index. MSCI starts with all publicly available stocks listed in 23 emerging-markets countries. These stocks constitute the investable market universe. The index then sorts them on free-float-adjusted market capitalization and targets those representing the largest 99% of the investable universe by market cap. The index applies additional screens for liquidity and foreign ownership eligibility to make it easier to track. This resulting index portfolio includes more than 2,700 constituents. The fund's advisor then fully replicates the index among the larger-cap names and uses a representative sample of smaller index constituents. This results in a portfolio of approximately 1,900 stocks that mimics the investment profile of the index and helps minimize costs.

The fund charges an annual fee of 0.16%, which makes it one of the cheapest options in the category. The average expense ratio for the category is 1.46%. During the trailing three years through August 2016, the fund has trailed its benchmark by 0.02% annualized. This is partially attributable to securities-lending revenue, which helps offset the fund's expenses.

Schwab Emerging Markets Equity ETF (SCHE) is the cheapest emerging-markets ETF, with a 0.14% expense ratio. This market-cap-weighted fund focuses only on large- and mid-cap companies.

 Vanguard FTSE Emerging Markets ETF (VWO) (0.15% expense ratio) recently transitioned to a new FTSE index that will begin including China A-shares. VWO is also available in a mutual fund format,  Vanguard Emerging Markets Stock Index (VEMAX), with a $10,000 minimum investment for the Admiral share class.

More risk-averse investors might consider  iShares Edge MSCI Minimum Volatility Emerging Markets (EEMV) (0.25% expense ratio). It attempts to construct the least-volatile portfolio possible with the stocks in the MSCI Emerging Markets Investable Market Index under a set of constraints. These include keeping country and sector weightings within 5% of the index.

Deutsche X-trackers MSCI Emerging Markets Hedged Equity (DBEM) (0.65% expense ratio) and iShares Currency Hedged MSCI Emerging Markets (HEEM) (0.68% expense ratio) both offer currency-hedged portfolios to protect against the volatility of emerging-markets currencies.

 DFA Emerging Markets (DFEMX) (0.57% expense ratio) and  DFA Emerging Markets Core Equity (DFCEX) (0.62% expense ratio) provide broad, indexlike exposure but with the trading benefits of active management. Both employ constraints to limit country exposure to less than 15%. DFA Emerging Markets Core Equity has more-pronounced value and small-cap tilts. For retail investors, these funds are accessible only through DFA-approved financial advisors and certain 401(k) and 529 college-savings plans.

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