3 Reasons to Reconsider Emerging Markets ETFs

On fears that Cyprus (a eurozone member with a population of just 1 million) could go bankrupt, see a run on its banks and depart the common currency program, emerging markets ETFs are languishing through another rough day.

For example, the Vanguard FTSE Emerging Markets ETF (NYSE:VWO) and the iShares MSCI Emerging Markets Index Fund (NYSE:EEM), the two largest emerging markets ETFs by assets, are both off about 0.7 percent.

In other words, Monday is proving to be an extension of a glum trend for emerging markets ETFs in 2013. The upside is there are a few reasons to consider the asset class, as iShares Global Chief Investment Strategist Russ Koesterich points out.

Not surprisingly given the recent tumble in shares of developing world equities, one reason is attractive valuations.

"Emerging market (EM) equities are trading at 1.5x book value, while developed markets (DM) are trading at 1.8x," said Koesterich in a recent research note. "The United States is trading at 2.15x. On a price-to-earnings (P/E) basis, emerging markets are still trading for a bit more than 12x trailing earnings, a 30% discount to developed markets. Some valuation discount is justified given higher profitability in the developed world, but the current valuation discrepancy looks excessive."

One market that stands out as inexpensive is Russia. The "R" in the famous BRIC acronym, which historically trades at a discount to the broader emerging markets universe, is currently heavily discounted even by its own long-tern standards.

The average P/E ratio of the MSCI Russia Index over last 10 years (as of January 31, 2013) is approximately 8.9 times, or nearly double current levels, according to WisdomTree research.

Koesterich also notes emerging markets fundamentals look sound and that developing world economies should outpace their developed peers in terms of economic growth this year.

"In addition, unlike in 2010 when faster emerging market growth came with an unhealthy dose of inflation, with a few notable exceptions like India, inflation is within the target zone of most emerging market central banks," said Koesterich. "Finally, the majority of the emerging market countries have much less fiscal baggage than their developed market counterparts. For developed countries, gross government debt is well above 100% of gross domestic product; in emerging markets, the ratio is just 34%."

Koesterich also highlighted the potential for incremental returns driven by emerging markets currencies that are undervalued relative to the U.S. dollar. The strategist highlighted Brazil as one exception.

"With the exception of Brazil, most emerging market currencies appear undervalued relative to the dollar. If that gap closes over time, this will be a source of incremental returns," he said.

Koesterich pointed to Brazil, China and Russia as the specific emerging markets he currently likes while suggesting the iShares MSCI Emerging Markets Minimum Volatility Index Fund (NYSE:EEMV) for investors looking to dodge developing world volatility.

EEMV, which has $1.6 billion in assets under management, is down just over one percent this year making the low volatility offering a better performer on a year-to-date basis than EEM and VWO. Taiwan and China combine for about 29 percent of EEMV's weight while South Korea and Malaysia combine for another 17.2 percent.

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