Seeking Better Emerging Market Diversification

by: Bennington Investment Ideas

Investors the world over often have a strong bias for their own home markets and often fail to seek diversification through investments in other countries and markets. However, the world's financial markets seem to be substantially interlinked. The events of 2008 showed that all markets can become highly correlated.

Many popular emerging market ETFs have relatively strong correlations to U.S. markets. However, these ETFs usually consist of larger companies that trade on multiple exchanges or can be purchased as American Depository Receipts (ADRs). For example, iShares MSCI Brazil Capped (NYSEARCA:EWZ) is driven by a few well known stocks. Its top 10 holdings make up 48.7% of its net assets.

However, while some larger capitalization stocks drive the major emerging market ETFs, there are specific ETFs focused on smaller capitalization stocks. While in a previous article, I showed that U.S. small capitalization ETFs do not offer significant diversification benefits from a portfolio volatility reduction perspective, there might be differences with international small-capitalization ETFs. These might offer superior diversification benefits and at least different exposures than their larger-cap counterparts. This article will look at the a series of ETFs in comparison to the benchmark portfolio defined by the SPDR S&P 500 Trust ETF (NYSEARCA:SPY). It is important to note that this analysis is U.S. centric and will not necessarily be beneficial to non-U.S. investors. Non-U.S. investors would have to consider what their benchmark portfolio is and compare that to the various ETFs. A given correlation between SPY and EWZ will not necessarily be the same with say iShares MSCI United Kingdom Index (NYSEARCA:EWU). Furthermore even if EWZ and SPY and EWU and SPY both have high correlations, this does not necessarily mean that EWZ and EWU would have a high correlation. The following ETFs were considered for this analysis:

Select ETFs
Ticker Name Recent Price Net Assets ($ B)* Type
SPY SPDR S&P 500 Trust ETF 163.02 129.8 Large cap
EWZ iShares MSCI Brazil Index Fund 41.47 6.1 Large cap
BRF Market Vectors Brazil Small-Cap ETF 29.72 0.5 Small cap
EEM iShares MSCI Emerging Markets Index Fund 37.34 45.6 Large cap
EWX SPDR S&P Emerging Markets Small Cap ETF 43.58 0.9 Small cap
ILF iShares S&P Latin America 40 Index Fund 35.10 1.5 Large cap
LATM Market Vectors Latin America Small-Cap Index ETF 18.53 11 million Small cap
FXI iShares FTSE/Xinhua China 25 Index Fund 32.07 5.2 Large cap
ECNS MSCI China Small Cap Index Fund 39.25 30 million Small cap
HAO Guggenheim/AlphaShares China Small Cap Index ETF 21.63 0.3 Small cap
MCHI iShares MSCI China Index 39.99 1.3 Large cap
Click to enlarge

Source: Yahoo!Finance

The first consideration is to compare correlations. I'll look at 24-, 36- and 60-month correlations using monthly data:

Ticker Type Correlation 24 months Correlation 36 months Correlation 60 months
SPY Large cap 100.0% 100.0% 100.0%
EWZ Large cap 80.8% 80.0% 80.0%
BRF Small cap 70.3% 64.3% NA
EEM Large cap 83.4% 82.3% 86.5%
EWX Small cap 84.6% 79.1% 83.9%
ILF Large cap 85.6% 84.2% 84.9%
LATM Small cap 78.6% 72.3% NA
FXI Large cap 69.4% 67.8% 72.2%
MCHI Large cap 73.1% NA NA
HAO Small cap 70.6% 68.1% 72.6%
ECNS Small cap 67.1% NA NA
Click to enlarge

Source: Yahoo!Finance for split and dividend adjusted monthly prices, author calculations.

So one can see that the smaller-cap versions often have lower correlations than the larger-cap versions. This is most pronounced in Latin American with BRF versus. EWZ and ILF vs. LATM. It is less true with the broader emerging markets of EEM versus EWX and also for the two sets of Chinese ETFs.

The next question is how they compare in terms of volatility. I would expect the smaller-cap versions to be more volatile than the larger-cap versions. This is often true of domestic ETFs. The following table compares volatility.

Ticker Type Monthly Volatility 24 months Monthly Volatility 36 months Monthly Volatility 60 months
SPY Large cap 3.8% 3.7% 5.3%
EWZ Large cap 8.4% 7.6% 10.0%
BRF Small cap 9.8% 8.7% NA
EEM Large cap 6.9% 6.3% 8.3%
EWX Small cap 7.4% 6.6% 9.0%
ILF Large cap 6.8% 6.2% 8.6%
LATM Small cap 8.3% 7.5% NA
FXI Large cap 7.8% 6.8% 8.4%
MCHI Large cap 7.2% NA NA
HAO Small cap 8.8% 7.8% 10.0%
ECNS Small cap 8.8% NA NA
Click to enlarge

Source: Yahoo!Finance for split and dividend adjusted monthly prices, author calculations.

As expected, the smaller-cap versions consistently had higher volatility across all geographies and time frames. The final consideration is to put them together to see if there is a reduction in portfolio volatility. The comparison is between the SPY portfolio and a new portfolio with 50% of SPY and 50% of the given ticker.

Portfolio Impact
Ticker Correlation Security Volatility New Portfolio Volatility Volatility Impact
SPY 100% 3.8% 3.8% 0.0%
EWZ 81% 8.4% 5.8% 2.1%
BRF 70% 9.8% 6.3% 2.6%
EEM 83% 6.9% 5.1% 1.3%
EWX 85% 7.4% 5.4% 1.6%
ILF 86% 6.8% 5.1% 1.3%
LATM 79% 8.3% 5.8% 2.0%
FXI 69% 7.8% 5.4% 1.6%
MCHI 73% 7.2% 5.1% 1.4%
HAO 71% 8.8% 5.9% 2.1%
ECNS 67% 8.8% 5.8% 2.0%
Click to enlarge

Source: Yahoo!Finance for split and dividend adjusted monthly prices, author calculations.

The above table shows that in all cases the volatility is higher with the addition of these emerging market ETFs. Furthermore, even though the small-cap ETFs had lower correlations, their higher volatility offset that benefit. So the benefits of small-cap emerging market ETFs would have to be around returns and not around volatility reduction.

Disclosure: I am long SPY, EWZ, BRF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.