Good News: Emerging Markets ETFs Are Cheap

Well-documented have been the struggles of some emerging markets ETFs to start 2013. Among diversified funds, the two largest emerging markets ETFs, the Vanguard FTSE Emerging Markets ETF (NYSE:VWO) and the iShares MSCI Emerging Markets Index Fund (NYSE:EEM), are each off nearly two percent year-to-date.

At the country-specific level, fears of tighter monetary policy and a property bubble have hampered China ETFs. Slowing economic growth has plagued Brazil while India ETFs have have tumbled amid concerns the country will lose its investment-grade credit rating.

All of that is to say 2013, to this point, has been a challenging year for emerging markets bulls. If there is good news it is this: The aforementioned declines mean some emerging markets ETFs are now sporting attractive valuations.

Newly released research from WisdomTree (NASDAQ:WETF) shows that while valuations may be compelling in the emerging markets universe, investors should also pay attention to trailing 12-month dividend yield.

WisdomTree Research Director Jeremy Schwartz split the 24-year history of the MSCI Emerging Markets Index, the index EEM tracks, into high dividend years and low dividend years. High dividend years are those that start with a trailing 12-month dividend yield above the MSCI Emerging Markets Index median of 2.25 percent, according to the research note.

"Higher trailing 12-month dividend yields indicate that a greater amount of aggregate dividends has been generated over the past 12 months relative to the current share price, while lower trailing 12-month dividend yields indicate the opposite," said Schwartz.

Schwartz notes that following high dividend years, the MSCI Emerging Markets Index returned an average of 33.03 percent compared to its average 24-year return of 17.47 percent.

EEM currently has a P/E ratio of 18.18 and a 30-day SEC yield of 2.07 percent, according to iShares data. Investors looking for a more deeply discounted valuation with a higher yield do have options among diversified emerging markets ETFs, including the WisdomTree Emerging Markets Equity Income Fund (NYSE:DEM).

DEM, which has almost $5.4 billion in assets under management, tracks the WisdomTree Emerging Markets Equity Income Index. That index had a P/E ratio of just 10.8 at the end of last year. Additionally, that index has been about 500 basis less volatile than its MSCI equivalent since inception, according to WisdomTree data.

DEM tracks the performance of the highest yielding stocks selected from its index, usually those in the top 30 percent by yield. That leads to some different country exposures than what EEM or VWO investors may be accustomed to. While DEM is heavy on the usual emerging markets suspects such as China, Taiwan and Brazil, the ETF also features an almost 13 percent allocation to Russia. That higher exposure to Russia has recently sparked some concern that DEM may become more volatile than its rivals.

However, Russian firms are highly profitable relative to other developing markets and the government there has moved to force more of the state-owned companies to pay higher dividends. Not to mention, Russian equities have a history of trading at a discount to the broader emerging markets universe. The iShares MSCI Russia Capped Index Fund (NYSE:ERUS) currently has a P/E of just over 10.

Bottom line: If past performance is any indicator, investors will want some emerging markets exposure coming off a high dividend year, as Schwartz notes.

"Four of the five best yearly return periods for the MSCI Emerging Markets Index followed trailing 12-month dividend yields that ranked among the five highest of all 24 calendar year returns. Notably, at the 2008 year-end, the dividend yield on the MSCI Emerging Markets Index was 4.75% (the highest value) and the 12-month forward return of the index was 79.02% (the highest 12-month forward return)," he said.

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