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New Smart Beta Factor In Emerging Markets

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New Smart Beta Factor In Emerging Markets by Christopher Gannatti, Associate Director of Research, The WisdomTree Blog

While near-term allocators to emerging markets may not be easy to find, the economic difficulties in emerging markets (EM) can function as a catalyst for rethinking how these markets can be accessed. We’re finding that investors may not want to take all of the risk factors inherent to an MSCI Emerging Markets Index, traditionally the “beta benchmark” for emerging market equity investments. In other words, not all emerging markets are created equal in today’s macroeconomic landscape.

Investors May Not Desire to Invest alongside Emerging Market Governments

Investors in U.S. equities typically don’t see the U.S. government taking large, controlling equity positions in the largest publicly listed companies. EM governments, however, can and do tend to take control of such companies, in many cases either deeming them strategically important or looking for the source of revenue they can provide.

On August 18, 2014, WisdomTree launched an Emerging Markets ex-State-Owned Enterprises Index, which has been closely tracking the concept of EM firms owned by governments for more than one year. What we find:

  • The Beta Benchmark Is One-Third Exposed to Government Ownership: We define “state-owned enterprises” as firms with a greater than 20% ownership by a state or government entity. The MSCI Emerging Markets Index is weighted fairly consistently 30% to 33%1 toward these companies. In other words, strategies designed to track this Index are as much as one-third exposed to firms that are controlled by governments.
  • Financials, Energy and Telecommunication Services Tend to Be Largest “State-Owned” Sectors: We screen the universe of emerging markets companies annually, and as of the September 30, 2015, Index screening, more than 40% of the market capitalization of “state-owned” firms that we found was in the Financials sector. Beyond that, nearly 20% of the market capitalization was in Energy companies, and more than 10% was in Telecommunication Services. So, nearly three-quarters of the market capitalization of state-owned enterprises was in those three sectors.
  • More than 60% of the state-owned market capitalization was in China.2

Identifying Exposure to State-Owned Enterprises as a Potential Smart Beta Factor

In our view, the most important characteristic of any factor is a persistent experience of differentiated performance—either positive or negative—over time. We therefore analyzed the difference in performance between the WisdomTree Emerging Markets ex-State-Owned Enterprises Index and the MSCI Emerging Markets Index.

Emerging Market Equity Performance

Emerging Markets

  • While the MSCI Emerging Markets Index showcases a very challenging environment over the various periods that we show, it is notable that the WisdomTree Emerging Markets ex-State-Owned Enterprises Index has delivered outperformance of anywhere from 3.7% to 5.0%. We explore the reasons from both a sector and country perspective below.3

Sector Perspective on Ex-State-Owned Enterprises

We see the most positive contributions in relative performance in the Financials, Information Technology and Energy sectors. Within Financials, avoidance of firms in Brazil, China and even Greece is notable, in that many of these firms have faced very challenging performance environments. In Information Technology, the relative over-weight to Chinese companies—many of which list on the New York Stock Exchange—has benefited performance. In Energy, avoiding the largest companies in Brazil and China has helped relative performance. Of course, over these periods, the performance across nearly every sector in emerging markets was, in a word, challenged, so this was really a story of avoiding some of the worst performing firms as opposed to selecting companies that are actually seeing positive performance.

Country Perspective on Ex-State-Owned Enterprises

On the country level, the key to understanding the performance differences over these periods lies in understanding the China exposure. If China’s equities are market capitalization weighted and state-owned enterprises are not restricted, it is no accident that the largest companies—the big banks, the big energy firms—get significant exposure. If China’s equities, on the other hand, are subject to our approach of aiming to avoid exposure to state-owned enterprises, the large banks and energy firms tend to be eliminated, and information technology firms and insurance companies tend to get larger weights. The important goal is not to take a massive under-weight to China (or any country) but rather to recharacterize the exposure to avoid state-owned enterprises.

Implementing an Ex-State-Owned Enterprises Approach in Emerging Markets

The bottom line of the WisdomTree Emerging Markets ex-State-Owned Enterprises Index is that it defines an exposure to emerging market equities while aiming to take one risk—exposure to state-owned enterprises—off the table. Investors interested in learning more should look at the WisdomTree Emerging Markets ex-State-Owned Enterprises Fund (XSOE), which is designed to track this Index before fees and expenses.

1Source: Bloomberg, for period from 8/18/15 to 9/30/15.
2Sources for bullets 2 and 3: Standard & Poor’s, WisdomTree, with data as of 9/30/15 Index screening date.
3Sources for sector and country segments: Bloomberg, with data looked at from 8/18/15 to 12/30/15, as well as various subperiods defined as starting on 12/31/14, 6/30/15 and 9/30/15, but all ending 12/30/15.

Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Investments in emerging or offshore markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments. Funds focusing their investments on certain sectors and/or regions increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility. Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations.

The Fund invests in the securities included in, or representative of, its Index regardless of their investment merit, and the Fund does not attempt to outperform its Index or take defensive positions in declining markets. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.

The Global Industry Classification Standard (“GICS”) was developed by and is the exclusive property and a service mark of MSCI Inc. (“MSCI”) and Standard & Poor’s (“S&P”), a division of The McGraw-Hill Companies, Inc., and is licensed for use by WisdomTree Investments, Inc. Neither MSCI, S&P nor any other party involved in making or compiling the GICS or any GICS classifications makes any express or implied warranties or representations with respect to such standard or classification (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability and fitness for a particular purpose with respect to any such standard or classification. Without limiting any of the foregoing, in no event shall MSCI, S&P, any of their affiliates or any third party involved in making or compiling the GICS or any GICS classifications have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits), even if notified of the possibility of such damages.

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