For many investors, the preferred way of accessing emerging markets is to leave the burden of country selection at the door. That means embracing a mult-nation ETF such as the Vanguard MSCI Emerging Markets ETF (NYSE:VWO) or the iShares MSCI Emerging Markets Index Fund (NYSE:EEM).
Plenty of investors have made that choice. That much is evidenced by the fact that VWO and EEM are not only the largest and second-largest emerging markets ETFs, respectively. The duo also represents the third- and fourth-largest ETFs by assets of any kind. Combined, VWO and EEM have over $95 billion in assets under management.
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Despite the popularity of EEM, VWO and scores of other multi-country emerging markets funds, the number of country-specific options offering exposure to the developing world continues to proliferate. That could leave some investors wondering if a more granular approach can prove efficacious over time.
For now, EEM and VWO still track the same index, but that will change in the coming months as VWO parts ways with the MSCI Emerging Markets Index.
So for the purposes of this exercise, EEM will be the measuring stick of choice because it is a marquee emerging markets ETF to which no wholesale changes are anticipated in the near future. The exercise at hand is showing weather an ETF such as EEM or basket of funds tracking the country's represented in EEM perform better over time. Here are the different baskets.
Heavy Weights This theoretical basket is comprised of the iShares FTSE China 25 Index Fund (NYSE:FXI), iShares MSCI South Korea Index Fund (NYSE:EWY), iShares MSCI Brazil Index Fund (NYSE:EWZ) and the iShares MSCI Taiwan Index Fund (NYSE:EWT). Literally, those are the heavyweight countries in EEM, representing about 56 percent of EEM's total weight.
South Korea and Taiwan are viewed as being two of the more conservative emerging markets, so it is surprising to see that over the past three years, EWY's volatility is 29.5 percent. EEM's is 27 percent. Over that time EWY has returned 35.2 percent, an advantage of about 2,000 basis points over EEM. In other words, an investor picked EWY over EEM made a good choice.
The trick was ignoring the rest of this basket. Including dividends, EWT is up 14.7 percent since late October 2009, but EWZ and FXI are both in the red.
Low Volatility Low volatility emerging markets ETFs have increased in popularity, but neither EEM nor the funds that represent EEM's constituents are explicitly "low vol" ETFs. However, some countries have lower volatility than others.
This basket includes EEM's lower volatility nations as represented by the following ETFs: The iShares MSCI Chile Investable Market Index Fund (NYSE:ECH), iShares MSCI Mexico Investable Market Index Fund (NYSE:EWW), EWT and EWY.
Over the past three years, only EWY was more volatile, but investors were compensated for that added volatility with the aforementioned out-performance of South Korean stocks relative to EEM. ECH offered more than double EEM's returns over the past three years with almost 400 basis points less in volatility while EWW outpaced EEM by almost four-to-one while being 220 basis points less volatile.
Latin America Here, the four Latin American nations represented in EEM are measured against the multi-country fund. ETFs used for this exercise are ECH, EWW, EWZ, the iShares MSCI All Peru Capped Index (NYSE:EPU) and the Global X FTSE Colombia 20 ETF (NYSE:GXG). To be fair, GXG skews this basket because it is one of the best-performing ETFs of any kind since the March 2009 market bottom.
Even when accounting for almost 11 percent three-year decline in EWZ, the average return for these ETFs is 41.3 percent. With the exception of EWZ, all of have been less volatile than EEM since late October 2009. In 2012, EEM has outperformed ECH and EWZ, but trailed EPU, EWW and GXG.
Southeast Asia EEM's exposure to ASEAN nations, some of the fastest growing economies in Southeast Asia, is minimal. Combined, Malaysia, Indonesia and Thailand represent less than nine percent of the fund's weight.
With an allocation of less than one percent, the Philippines was excluded from this exercise. Including the iShares MSCI Thailand Investable Market Index Fund (NYSE:THD) skews things a bit because this ETF has more than doubled since October 2009. The Market Vectors Indonesia ETF (NYSE:IDX) is no joke, either, with a three-year surge of nearly 68 percent.
The iShares MSCI Malaysia Index Fund (NYSE:EWM) is the "laggard" with a gain of 56.3 percent. Only IDX has been more volatile than EEM over the past three years.
The Rub(s) To be sure, this exercise is not perfect if for no other reason than it is backward looking. There are no guarantees the countries that have outperformed EEM in the past will do so again. Of course, expenses play a factor. For example, EWW, EWZ and THD all have lower expense ratios than EEM's fees of 0.67 percent. However, fees of 0.52 percent, 0.59 percent and 0.59 percent spread over three investments is more costly than owning just one fund that charges 0.67 percent.
Bottom line: Even with these issues, a more granular approach to emerging markets can be useful to investors. If nothing else, owners of broad-based funds such as EEM should consider one or two country-specific funds to go along with EEM.
"Because each region or country has its own unique risk profile, building an equity portfolio with regional- or country-specific funds can offer the potential for higher risk-adjusted returns," iShares Global Chief Investment Strategist Russ Koesterich . "Implementing through regional or country funds allows an investor even one without a strong view on country performance to assemble a portfolio that may be better diversified than a traditional cap-weighted benchmark. Through better diversification, we believe that it's possible for investors to assemble portfolios with a higher return-to-risk ratio." For more on emerging markets ETFs, click here.
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