How To Deal With Emerging Market ETFs If The Fed Raises Rates

The specter of the Federal Reserve raising interest rates has been one of the most often cited reasons for the struggles of emerging markets stocks and it is a conversation that has been had since the first taper tantrum took place two years ago.

If the Fed looms so large for emerging markets, then disheartening it must be for investors to realize that as 10-year Treasury yields have lost more than 8 percent over the past 90 days, the MSCI Emerging Markets Index is lower by 19.6 percent over the same period. However, that does not erase the fact that plenty of companies and governments in emerging markets have issued debt denominated in U.S. dollars and the dollar is stronger today than it was several years ago. All that dollar-denominated debt will be a burden to issuers if U.S. short-term interest rates rise.

Quality Over Value

Assuming the Fed does proceed with raising interest rates, emerging markets investors should focus on quality over value. As a new research note from WisdomTree points out, the MSCI Emerging Markets Quality Index outperformed its value counterpart and the MSCI Emerging Markets Index during each of the last three Fed tightening cycles.

An ETF to consider when the next tightening cycle starts is the WisdomTree Emerging Markets Equity Income Fund (NYSE:DEM). DEM employs the quality factor via the ETF's dividend emphasis, which is cemented by a yield of almost 6.4 percent on the WisdomTree Emerging Markets High Dividend Index (WTEMHY).

DEM began trading on July 13, 2007, so we were unable to review live performance during past periods of Fed tightening. However, we can answer the question of which, if any, of WisdomTrees broad-based emerging market equity ETFs have lower leverage, which is one common measure of quality, said WisdomTree.

Impressive Returns

Another approach to quality that could prove durable when U.S. rates climb, is selecting companies that boast impressive return on assets and return on equity statistics. That is the cornerstone of DEM's dividend growth counterpart, the WisdomTree Emerging Markets Quality Dividend Growth Fund (NASDAQ:DGRE).

DGRE's underlying index sports a dividend yield that is well below that of DEM's index, but at almost 4.1 percent, is still impressive. Other perks include a combined weight to Russian and Chinese stocks of just over 8 percent. Those countries combine for nearly 41 percent of DEM, meaning investors can pair the two ETFs together without having to worry about excessive China and Russia exposure.

By way of reduced exposure to China and Russia, DGRE helps investors dodge sector-level trouble spots as financial services and energy names combine for just 12.5 percent of the ETF's weight. Those are DGRE's sixth- and seventh-largest sector allocations, respectively. That also means DGRE's exposure to state-controlled companies is lighter than many rival emerging markets ETFs.