Emerging Market ETFs Are Turning Around

The developing markets have been falling behind developed stocks for the past few years, but as once outperforming plays grow long in the tooth, investors are taking a second look at the more cheaply valued emerging market exchange traded funds.

Over the past five years, the Vanguard FTSE Emerging Markets ETF and iShares MSCI Emerging Markets ETF, the two largest emerging market plays, generated an average annualized return of -4.2% and -4.8%, respectively, while the S&P 500 Index returned 11.9%.

However, the developing markets are gaining momentum. Year-to-date, VWO increased 9.0% and EEM rose 8.8% while the S&P 500 Index gained 3.6%.

The emerging markets have been stabilizing and we are seeing increased flows into the space. Over the past week, VWO added $141 million in net inflows and EEM saw $47 million in inflows. The iShares Core MSCI Emerging Markets ETF, a slightly cheaper and more diversified option to EEM, attracted $255 million.

As commodity prices rebound and the emerging currencies appreciate, investors are taking notice of the attractive valuations that the developed markets have to offer. For instance, VWO shows a 12.51 price-to-earnings ratio and a 1.42 price-to-book. EEM has a 12.06 P/E and a 1.28 P/B, according to Morningstar data. In comparison, the S&P 500 is trading at a 17.22 P/E and a 2.34 P/B. Bargain hunters who are seeking a deal may find that the discount in emerging equities to U.S. equities is an attractive opportunity.

Moreover, as investors shift away from the growth style in favor of value, alternative or smart beta index-based ETFs, which typically exhibit a value tilt, may also gain traction.

For example, the WisdomTree Emerging Markets High Dividend Fund tracks a fundamentally weighted index that includes the highest dividend yielding stocks taken from the WisdomTree Emerging Markets Dividend Index and are weighted by annual cash dividends paid. DEM shows a 4.70% 12-month yield. DEM has a 9.18 P/e and a 1.08 P/B and increased 16.0% year-to-date.

There are a number of so-called smart-beta, enhanced, multi-factor or fundamental emerging market ETF options available as well. Among the largest options, the Schwab Fundamental Emerging Markets Large Company ETF (FNDE) tracks the Russell Fundamental Emerging Markets large Company Index, which selects, ranks and weights components based on fundamental factors like adjusted sales, retained operating cash flow and dividends plus buybacks. FNDE has a 9.67 P/E and a 0.78 P/B and rose 19.6% year-to-date.

The PowerShares FTSE RAFI Emerging Markets Portfolio, which tracks the FTSE RAFI Emerging Markets Index, is a fundamentally-weighted ETF focusing on the virtues of book value, cash flow, sales and dividends. PXH has a 10.18 P/E and a 0.91 P/B and advanced 18.7% so far this year.

The First Trust Emerging Markets AlphaDEX Fund is based on growth factors like three, six and 12-month price appreciation, sales to price and one year sales growth, along with value factors, including book value to price, cash flow to price and return on assets. FEM has a 10.15 P/E and a 1.03 P/B and returned 9.2% year-to-date.

The SPDR MSCI Emerging Markets Quality Mix ETF, which tries to reflect the performance of the MSCI Emerging Markets Quality Mix, targets emerging stocks based on value, low volatility and quality strategies and then equally weights the combination. QEMM has a 12.64 P/E and a 1.46 P/B and added 7.0% year-to-date.

The FlexShares Morningstar Emerging Markets Factor Tilt Index Fund takes a traditional smart beta approach with its emphasis on small-caps and value stocks, along with fundamental characteristics like return variability and yield. TLTE has a 9.70 P/E and a 0.95 P/B and was up 7.9% year-to-date.

A number of fund sponsors have also enter the space with alternative index-based ETF options to differentiate their offerings from traditional market cap-weighted index funds. For instance, the Legg Mason Emerging Markets Diversified Core ETF breaks down the universe of securities into investment categories based on sectors and countries. The five-year return patterns of the countries and sectors are taken to uncover relationships – areas that behave alike or differently. The underlying index then combines investment categories with more highly correlated historical performance into smaller number of so-called clusters, which are categorized based on tendency to behave similarly, or show various correlations. Each of these clusters are then equally weighted individually and also equally weighted across the portfolio to produce a diversified investment strategy. EDBI has a 14.04 P/E and a 1.58 P/E and gained 12.2% year-to-date.

The Goldman Sachs ActiveBeta Emerging Markets Equity ETF tracks the ActiveBeta indexing methodology, which provides exposure to common investment factors like value, momentum, quality and low volatility in an attempt to outperform broader benchmarks with potentially smaller drawdowns. GEM has a 12.15 P/E and a 1.35 P/B and was up 7.3% year-to-date.

The JPMorgan Diversified Return Emerging Markets Equity ETF tracks the FTSE Emerging Diversified Factor Index, which incorporates a multi-factor screening process that combines value, momentum and quality factors. JPEM has a 11.98 P/E and a 1.42 P/B and increased 10.8% so far this year.

The recently launched Deutsche X-trackers FTSE Emerging Comprehensive Factor ETF tries to reflect the performance of the FTSE Emerging Comprehensive Factor Index, which targets emerging market equities based on five factors, including quality, value, momentum, low volatility and size.

This group of alternative index-based ETFs allow investors to diversify away from traditional market capitalization-weighted indices that may be overly exposed to a specific group of countries or sectors. For instance, the FTSE Emerging Markets Index includes about a 50% tilt toward South Korea, China and Taiwan, along with a 80% weight toward the BRICs – Brazil, Russia, India and China. In contrast, DEMG shows a weight of 16.5% toward South Africa, 15.2% China, 12.1% Taiwan, 8.6% Brazil, 8.6% Mexico, 7.6% India, 6.9% Malaysia, 4.2% Russia, Thailand 3.7% and Chile 3.1%. Investors may consider taking a more diversified approach to the developing world through non-market-cap-weighted funds.

This article was provided by our partners at etftrends.com.

Full disclosure: Tom Lydon’s clients own shares of PXH and FNDE.