Trends in Emerging Markets ETFs

 

The rise of the Exchange Traded Fund (ETF) over the past decade has been a huge benefit for the investor in emerging market. ETFs give investors access to the broad asset class with low fees and significant tax advantages. Increasingly, these same benefits are provided to investors looking for exposure to specific countries and various investment factors. All of these products together provide the tools for the both the passive and active investor to develop intelligent and cost-efficient strategies for investing in emerging markets.

ETF emerging market assets are highly concentrated, with the ten largest funds gathering 81% of the $240 billion invested in U.S. listed ETFs.  These include the mammoth core emerging markets ETFs that follow the primary EM benchmarks provided by FTSE-Russell  (Vanguard) and MSCI (Blackrock-iShares). Fees for these funds have been consistently reduced and are now about 0.14% of assets. A clear indication of the relentless downside pressure on fees is that in 2012 Blackrock had to launch a new lower-fee core emerging markets fund, IEMG, to compete with its own original EEM fund. EEM continues to charge its legacy fees of 0.69%, but gradually is losing ground. Newcomers, Charles Schwab, and State Street, have secured market share by taking fees even lower.  Schwab’s FTSE-based core EM ETF, SCHE, currently has a 0.13% fee, and State Street’s SPEM ETF, benchmarked to the S&P BMI Emerging Markets Index has lowered its fee to 0.11%.

A similar story is unfolding with country-specific ETFs, a category until today largely dominated by Blackrocks’s MSCI-based iShares. The big funds in this space are iShares Brazil (EWZ), iShares India (INDA), iShares Taiwan (EWT), iShares China Large Cap (FXI, iShares China MSCI (MCHI) and iShares Latin America (ILF). All of the iShares country-specific products have maintained fees above 0.60%. So far, Ishares, with its first-mover advantage and the superior liquidity of its shares, has felt limited competition in this space, but that may be changing. This year Franklin Templeton launched a family of FTSE-based country funds under the Franklin LibertyShares label with 0.09% a fee for developed markets and a 0.19% fee for emerging markets. Brazil, China, Taiwan, Russia and Mexico have already been launched with good traction.

Another interesting trend in emerging markets ETFs are “Smart Beta” funds. This is a vague term that has come to include a category of products that feature a quantitative tilt towards specific valuation attributes (factors) or portfolio structures that aim to enhance returns. Most of these funds seek to exploit the “investment factors” —  value, size, momentum, and quality – that have been shown by long-standing academic research to improve portfolio returns over the long term. These techniques, commonly espoused by active managers, tilt portfolios towards stocks with low price-to-book ratios (value), smaller stocks (size), rising stocks (momentum) and stocks with strong balance sheets and steady returns (quality). Moreover, academic research supports the idea that portfolio returns can also be enhanced by changing the weights of stocks in a portfolio from one based on market capitalization to one based on equal weights or one based on fundamental factors, like sales, cash flows or book values.

Smart Beta funds were initially launched with higher fees, in the 0.7% range. However, fee compression is affecting these products as well, and recent launches are charging fees closer to 0.3%.

Some ETFs following the Smart Beta  track include Goldman Sachs Active Beta Emerging Markets (GEM) (value, momentum, quality, low volatility); Invesco, whose Powershares FTSE RAFI EM (PXH) weighs its portfolio positions based on book value, cash flow, sales and dividends,  a fundamental value strategy; Northern Trust EM Factor Tilt (TLTE) (small caps and value); FirstTrust EM AlphaDEX (FEM) (value and quality); SPDR EM Small Caps (EWX); and JPMorgan’s Diversified Return EM Equity (JPEM) (value, quality, momentum).

The chart below shows the twenty largest EM ETFs, with factor tilts listed on the far right. The top twenty ETFs represent nearly 90% of the EM ETF assets in the U.S. market.

Source: ETF.Com

A very successful player in the “factor” space is Wisdom Tree (WT), which has its academic credibility supported by having Wharton’s Jeremy Siegel as its senior investment strategy advisor.  WT has funds tilted towards high dividend stocks; high dividends serving as a proxy for value, quality and corporate governance. These include a core EM ETF (DEM)  and a small cap EM ETF (DGS). WT also has an India ETF (EPI), with factor-tilts towards small caps, value and quality. Moreover, WT has launched both an EM ETF and a China ETF which avoid state-run companies. This seeks to tilt the portfolio towards higher quality companies with better corporate governance, under the assumption that very few state-run companies care about creating value for minority shareholders.

WT  has the advantage that it cuts expenses by creating its own indices. This strategy has also been followed by Van Eck Funds and Cambria, among others, and this is adding pressure on the leading index providers  (FTSE and MSCI) to further reduce fees.

In conclusion, this plethora of core EM funds, country and regional funds and factor-tilted smart beta ETFs means it has never been easier and cheaper to build intelligent EM strategies. The investor has the opportunity to generate significant alpha in emerging markets by strategically tilting portfolios towards countries and factors. Once this has been accomplished, 80-90% of the task is done. The remaining 10-20% —  capturing stock-specific alpha – is both the most difficult and the least important. For those investors with the skill, free-time and patience to do this, I recommend a portfolio overlay of one or a combination of the two following strategies:

  • Invest with an active manager with a highly concentrated, long-term oriented portfolio.
  • Invest in a 15-30 high quality EM blue chips which have very long investment runways, and hold for the very long-term.

Fed Watch:

  • The Fed’s ammunition ran out (Zerohedge)
  • High Wages and high savings in a globalized world (Carnegie)

India Watch:

  • Mohnish Pabrai on the Indian market (Youtube)
  • Half a billion mobile internet users in India (Quint)
  • Digital streaming is taking over cinema (Quint)

China Watch:

  • China airline threatens move to Airbus (SCMP)

China Technology Watch:

  • China 2017 tech strides (Youtube)
  • Transsion is the leading cel-phone in Africa (bloomberg)
  • China moves up the value chain (bloomberg)

Technology Watch

EM Investor Watch

  • Russia and China’s uneasy Far-East partnership (Carnegie)
  • Thailand is he next Japan (The Economist)
  • Korean millenials  feeling the Bitcoin pain (The Verge)
  • Sam Zell is back in Buenos Aires (WSJ)
  • EM countries getting old; the case of Brazil (WSJ)

Investor Watch: