Emerging Markets ETFs: It's Not All About The Dollar

Conventional wisdom has dictated that a large part of the problems being faced by emerging markets stocks and exchange traded funds are attributable to the strong U.S. dollar. On the surface, the reasoning makes sense.

Over the past year, the Vanguard FTSE Emerging Markets ETF (NYSE:VWO) and the iShares MSCI Emerging Markets ETF (NYSE:EEM), the two largest emerging markets ETFs by assets, are off an average of 24.8 percent while the PowerShares DB US Dollar Index Bullish Fund (NYSE:UUP), the U.S. Dollar Index tracking ETF, is higher by 11.6 percent.

The strong dollar suppresses commodities prices, a vital revenue driver for scores of developing governments from Moscow to Sao Paulo. Making matters worse is the perceived impact of the mighty greenback on dollar-denominatedemerging markets debt.

"According to a popular story, the strength of the U.S. dollar and the expected interest rate hikes by the Fed could trigger a new wave of troubles for emerging economies. 'If history is any guide,' writes Xie (2015), 'emerging markets are headed for trouble as the dollar strengthens.' Because of currency mismatches on their balance sheets, weak commodity prices, and deteriorating market sentiment, emerging market economies should be at risk of reenacting the Asian and Russian crises, perhaps on a larger scale," according to a recent note by Research Affiliates.

Smart Beta ETF

California-based Research Affiliates is the index provider for scores of well-known smart beta ETFs, including the PowerShares FTSE RAFI Emerging Markets Portfolio (NYSE:PXH). PXH has not been immune to the downdraft that has slammed emerging markets ETFs as the fund has tumbled 34.8 percent over the past year.

On the other hand, PXH offers significant leadership potential if, and admittedly it is a big "if," emerging markets equities earnestly rebound. Consider that if the Federal Reserve raises interest rates, another factor widely cited as a problem for developing economies, it may not be all bad news for emerging markets stocks.

"Yet higher interest rates can be good news if they signal stronger economic performance. Solid growth rates tend to be associated with higher interest ratesthis is the meaning of a real shockand the rest of the world can benefit from strong U.S. growth. Indeed, the United States is still the worlds largest economy, and an improvement in U.S. economic performance should pave the way for expansion at the global level," notes Research Affiliates.

PXH's underlying index selects the ETF's nearly 340 holdings based on book value, cash flow, sales and dividends. The dividend emphasis leads to a trailing 12-month yield of 3.33 percent, or 86 basis points higher than the comparable metric on the MSCI Emerging Markets Index.

With a price-to-earnings ratio of just under 11.5, the $326.5 million PXH jibes with the notion that emerging markets equities are currently inexpensive, though that is partly attributable to slack earnings growth throughout developing economies.

Part of the silver lining revolves around the fact that developing economies are not as vulnerable to financial shocks today as they were in the 1990s.

"We can start by noting that some emerging central banks have actually cut their benchmark rates over the last year or so (e.g., Mexico, Thailand, Chile, South Korea, Poland, and Hungary). This is a noteworthy change with respect to the past, when these banks would typically increase interest rates in order to defend their currency from a sharp depreciation. Instead, nowadays these banks are fighting falling rates of inflation and production growth and, as in the developed markets, they tend to do so by easing liquidity conditions. Hence, weaker currencies should be seen as being part of their broader policy goals, somewhat as they are in Japan and the Eurozone," notes Research Affiliates.

Asian countries combine for half of PXH's weight while the ETF allocates over 21 percent of its weight to Brazil and Mexico, Latin America'stwo largest economies.