Intelligently Investing In EMs Easier Said Than Done: The Largest EM ETFs Haven’t Kept Pace With Changing Landscape by Bryce Coward, CFA, Gavekal Capital

Emerging Market (EM) equities have had all sorts of trouble so far in 2015. For US dollar based investors, weakening EM currencies coupled with falling stocks in local currency terms has led the preeminent emerging market stocks index  – the MSCI Emerging Markets Index – to be down roughly 17% from it’s recent high. As a rule of thumb, US dollar strength is bad for EMs (since many companies fund themselves with US dollar denominated debt that is harder to pay back when the dollar rises). US dollar strength coupled with a generalized fall in commodity prices is even worse (since many EMs are heavily reliant on exports of raw materials). US dollar strength coupled with falling commodity prices and a noticeably slowing China is for many EMs a worst case scenario.Luckily for investors with an underweight to EMs, the washout currently taking place could be setting up for a pretty interesting investment scenario, as we recently highlighted.  Yet, actually implementing such an investment is quite a bit more nuanced than generally appreciated. There are of course plenty of easily accessible and cheap ETFs to chose from, but based on our work the incumbent lineup of investable products is insufficient for a rapidly changing EM investment landscape.  There are two primary reasons this is so. First, most EM stock indexes (like the MSCI EM Index or the FTSE Emerging Index) are market capitalization weighted. Market capitalization weighting schemes are not in and of themselves inherently bad, but in the EM the bulk of the market capitalization is represented by yesterday’s “old economy”, state-owned sectors such as financials, energy, materials, telecom and utilities. Just like market capitalization weighting schemes, there is nothing inherently wrong with these sectors, but many (not all) of the companies that compromise them benefit to a large degree from things like accelerating infrastructure spending, rising commodity prices, a weak US dollar, falling corporate interest rates and a booming China. In what appears to be a great confluence of events (or perhaps they are all somewhat related!), we are now seeing the opposite of all these things at once. Importantly, however, the fastest growing segments of the EM economies – the consumer areas, health care, technology, and industrials – are grossly underrepresented in market capitalization weighted indexes, yet they offer the best opportunity for growth and investment success. It is indeed the stated goal of many EM countries, China most notably, to increase the share of consumption in the economy. This bullish tailwind should be exploited, not diminished in investment portfolios.The second reason the incumbent lineup of EM investment vehicles is insufficient (especially in the ETF space) is that for the most part they track the indexes that are themselves market capitalization weighted and heavily skewed toward the state-owned darlings of yesteryear.

To illustrate these points we’ll bring in some data. The first table below shows a summary breakdown of the MSCI Emerging Market Index by GICS sector using both the capitalization and equal weighting methodologies. From here we can easily see the large overweight the financial sector gets in the market capitalization weighting method.

EM ETFs

In the second table below we aggregate the “old economy” sectors (financials, energy, materials, telecom, utilities) and the “new economy” sectors (consumer discretionary, consumer staples, health care, information technology, and industrials) so we can get a clearer glimpse of the distortion created by the market capitalization weighting methodology. Using the capitalization weighting method the “old economy” sectors represent 55% of the EM stock index, but from an equal weighted standpoint they represent just 41.5% of the index. Said another way, there are a lot more companies in the fast growing consumer and high-tech areas of emerging market economies, but they are vastly underrepresented by both the standard EM indexes as well as the incumbent lineup of investable products. 

EM ETFs

Addressing this last point about the composition of the largest investable products, the first table below shows the ten largest ETFs by net assets that are designed to offer investors cheap and easy access to the diversified emerging markets space. The table underneath it shows the categorization of these ETFs between market capitalization weighted, smart beta or sector equity. The overwhelming majority of the investment dollars in these largest ETFs has flowed into investment vehicles that are heavily affected by the market capitalization distortions we just touched on. Specifically, almost 93% of the assets of these largest ten diversified emerging markets ETFs are housed in VMO (tracks the FTSE Emerging Market Index) and EEM (tracks the MSCI EM Index), both of which are incredibly skewed towards the low growth, “old economy” sectors that savvy investors might consider down playing in favor of comparatively faster growing “new economy” sectors. A further 4% of the assets are housed in DEM, DGS and EDIV, which offer a different weighting format based on dividend yields. The problem with these is that the companies that pay the largest dividends tend to be in the “old economy” sectors previously mentioned, and in fact the skewing towards the “old economy” sectors is in two cases even more pronounced than in VWO and EEM. The allocation to old economy sectors for DEM is 81.53%, for DGS it is 38.55% and for EDIV it is 64.47%. 1% of the combined assets of these largest diversified EM ETFs are in ECON, but ECON is hardly a diversified investment vehicle since it is designed to track the Dow Jones Emerging Markets Consumer Titans 30 Index. The Down Jones Emerging Markets Consumer Titans 30 Index is composed of the 30 largest companies in the Consumer Goods and Consumer Services industries. The last two ETFs on the list, FEM and PXH, are indeed smart beta ETFs in that the weighting of companies in these products is based on fundamental factors other than just market capitalization. But we find that the allocation to the “old economy” sectors is higher still than the benchmark indexes. The weighting to the “old economy” sectors for FEM is 65.97% and for PXH it is 77.46% So at the end of the day, out of the largest ten ETFs in the diversified emerging markets space, not a single ETF offers investors diversified exposure to the fastest growing segments of EM economies (we don’t count DGS because a small cap dividend fund is a fairly niche product and the allocation to the growth sectors is still just above 60%).  

10 Largest Diversified EM ETFs:

EM ETFs

EM ETFs

*AUM as of end of 2Q 2015

Clearly, this poses a problem for the investing public. The stated goal of the second largest economy in the world in conjunction with other EM economies is to raise per capita incomes and grow the consumer parts of the economy. They are also actively seeking to move up the value chain in manufacturing and produce higher tech goods and services. So how does one gain cheap, diversified exposure to EMs, but do so in a strategic manner so as to maximize exposure

1, 2  - View Full Page