Slide in EM ETF Exposes Country Weight Flaws

With the first quarter almost in the books, it is fair to say that one of the more prominent ETF themes in the first three months of the year has been disappointment at the hands of diversified emerging markets ETFs.

Not to pick on the iShares MSCI Emerging Markets Index Fund (NYSE:EEM), but the MSCI Emerging Markets Index is marquee benchmark for professional investors all over the world. Heading into the start of trading Wednesday, EEM was down 4.1 percent year-to-date.

The laggard status of EEM and related ETFs somewhat obfuscates the fact that not all country-specific ETFs tracking developing world nations have been disappointments this year. Arguably, that point shines a light on the flawed country composition of some diversified emerging markets funds.

Sticking with EEM, that ETF is heavily allocated to China, South Korea, Brazil and Taiwan. Those are the only nations to receive double-digit weights in that fund. The quartet combines for about 56 percent of EEM's weight. Since this is a market capitalization-weighted ETF, there is also decent exposure to South African, Indian and Russian equities. That trio combines for another 19.4 percent of EEM's country weight.

So what investors get is seven countries representing over three-quarters of EEM's weight. With that in mind, it is no surprise EEM is down this year. Performances by the major ETFs tracking EEM's seven largest country weights tell the tale. Simply put, the best of the seven is the iShares MSCI Taiwan Index Fund (NYSE:EWT), which was down 2.2 percent at the start of trading Wednesday.

The iShares FTSE China 25 Index Fund (NYSE:FXI) was lower by 7.8 percent while the iShares MSCI South Korea Index Fund (NYSE:EWY) was down 6.2 percent. The iShares MSCI Brazil Capped Index Fund (NYSE:EWZ) was down four percent. Bottom line: The average return by the ETFs tracking the four largest countries in EEM was -5.05 percent heading into Wednesday's trading session.

Things get ugly in a hurry when factoring in the iShares MSCI South Africa Index Fund (NYSE:EZA), the WisdomTree India Earnings ETF (NYSE:EPI) and the Market Vectors Russia ETF (NYSE:RSX). The average year-to-date return among that trio is -8.93 percent.

Now consider the next seven countries represented in EEM. In order of weight within the ETF that group is Mexico, Malaysia, Indonesia, Thailand, Turkey, Chile and Poland. Obviously, these countries do not account for much, or enough in the eyes of some investors, of the MSCI Emerging Markets Index. For example, Mexico, Malaysia and Indonesia comprise just 12 percent of EEM's weight.

That is too bad because even when accounting for the two percent year-to-date slide in the iShares MSCI Malaysia Index Fund (NYSE:EWM), that ETFs along with the iShares MSCI Mexico Investable Market Index Fund (NYSE:EWW) and the Market Vectors Indonesia ETF (NYSE:IDX) are up an average of almost 4.2 percent this year.

To be fair, a 14.1 percent tumble for the iShares MSCI Poland Investable Market Index Fund (NYSE:EPOL) weighs on the group including that ETF, the iShares MSCI Thailand Investable Market Index Fund (NYSE:THD), the iShares MSCI Turkey Investable Market Index Fund (NYSE:TUR) and the iShares MSCI Chile Investable Market Index Fund (NYSE:ECH). Still, that quartet is flat on an average return basis.

Overall, the average year-t return for the ETFs tracking the second group of seven countries in EEM is 2.24 percent. For the top seven country weights in EEM, the average return on an ETF-by-ETF basis is -6.71. This dichotomy confirms bigger is not always better, at least not with country weights in diversified emerging markets ETFs.

For more on EM ETFs, click here.