Delfeld: Most Investors Significantly Underweight Emerging Markets

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 |  Includes: AFK, BRF, DIA, EEM, EGPT, EMB, EUO, EWY, EWZ, HAO, IDX, IOO, IWC, PMNA, PXR, TLT, TUR, UUP, VWO
by: Carl T. Delfeld

Boulder, Colorado-based financial investment advisor and publisher Carl Delfeld began 2010 with a bang, launching ETF Passport, a newsletter and hands-on ETF advisory service for institutional investors trying to navigate the increasingly complex ETF marketplace. The launch comes after seven years (and counting) building up a following through ChartwellETF.com, which provides subscribers with a variety of ETF-specific commentary and portfolio recommendations.

Delfeld has been focused on the ETF market since 2002, with a specialty in Asian and Emerging Markets investing. He formerly was an institutional stockbroker in Tokyo, Hong Kong and Sydney, U.S. Representative to the Asian Development Bank, and an ETF Specialist for UBS. He has also authored four books on ETF global investing and is a columnist with Forbes Asia. He also serves on the advisory committee of ETF pioneer Main Management in San Francisco.

He recently took time out of his schedule to discuss his approach to ETF portfolio building with Seeking Alpha ETF Content Editor Jonathan Liss.

Jonathan Liss (JL): Before we get into portfolio building specifics, why launch another ETF Newsletter Carl? You already have one and anyway, isn't the market oversaturated with these sorts of products already?

Carl Delfeld (CD): I actually like to refer to ETF Passport as 'the anti-ETF newsletter', because of my unique approach. I limited myself to 10 institutional clients total with ETF Passport and every subscriber will have my direct line. I'm not only there to provide a newsletter every two weeks and then disappear. In fact, the published part of this service is just the start. This is really more of a research and advisory service for institutions that are having trouble following the rapidly expanding ETF marketplace and need someone they can rely on for constant advice regarding ETF selection, ETF portfolio construction, and strategies for Asia and emerging markets.

JL: Is ETF Passport focused exclusively on ETFs, or do you sometimes recommend other vehicles?

CD: This is another thing that sets my publications apart from your standard ETF newsletter. I am very open to blending stocks with ETFs (I worked as a stock picker for Baird), mutual funds and even the rare CEF if the discount and holdings are right. I think they can be blended very nicely into a portfolio. If something captures an investor's objectives most favorably, providing proper diversification and minimizing risk, I don't see any reason to oppose using it.

JL: Another interesting looking product I see you've created is the Chartwell Global GNP 30. What is that?

CD: The Chartwell Global GNP 30 is an actively managed portfolio that I created in April, 2005 as an alternative to the SPDR Dow Jones Industrial ETF (NYSEARCA:DIA). Like the Dow, it contains 30 stocks but company distribution mirrors global GNP share with 28% to North America, 27% to Europe, 12% to developed Asia and the balance to Emerging Markets. The selection of companies in my basket are driven by value and weighted equally with a target turnover of 15%-20%. In my experience and research, 30 holdings is the optimal number of holdings in terms of diversification. I make sure the index is well diversified across sectors and countries.

In terms of performance, since inception the Global GNP 30 has handily outperformed both the SPDR Dow ETF (DIA) and the S&P Global 100 (NYSEARCA:IOO).

The slogan for DIA is “Invest in America. Your grandparents did.” For the Global GNP 30, the slogan is “Invest in the world. Your children will thank you.”

JL: Let's discuss what seems to me (based on the focus of the majority of your articles for Seeking Alpha) to be your area of greatest interest: Emerging Markets. Why the emphasis on Emerging Market plays?

CD: Morningstar recently published a statistic which shows that only 2% of global mutual fund and ETF assets are in Emerging Market equities. This means that the average U.S.-based investor is incredibly underweight in an area that has the potential to deliver significant portfolio returns in the coming years.

That being said, if you look at the the performance of the MSCI Emerging Markets Index since its formation in 1986, it's down over the life of the index. Most Emerging Market investors make the mistake of riding the roller coaster of Emerging Market performance up and down. If you look at the performance of most Emerging Markets over the recent few years, the charts pretty much form a perfect 'V'. Due to the high volatility involved, buy and hold doesn't really work with Emerging Markets. The key is to choose the right markets and once in, to get out before they get expensive.

JL: Can we talk specifics. How are you currently positioning clients within Emerging Markets ETFs?

CD: Before I get into specifics, I'll briefly explain how we break things up. ETF Passport offers two different portfolios ('Global Core' and 'Emerging Markets Explore'), each comprised of five sections. Within our 'Global Core' Portfolio, we divide things by 'Core Equity', 'Country/Sector', 'Commodity', 'Fixed Income/Currency' and 'Cash/Inverse'. Within 'Emerging Markets Explore', the breakdown is as follows: 'Core Equity', 'Country', 'Sector', 'Fixed Income/Currency' and 'Cash/Inverse'. We then recommend clients choose some mix of the two, diversifying between a basket of non-emerging global equities and asset classes and a broad basket of Emerging Market holdings.

As of mid-February, the top holding was Vanguard Emerging Markets ETF (NYSEARCA:VWO), which made up 20% of the total Emerging Markets basket.

JL: And you prefer that to iShares MSCI Emerging Markets Index ETF (NYSEARCA:EEM). Why?

CD: It's cheaper and better tracks the underlying [MSCI Emerging Markets] index. However, I don't think there's a major difference between them.

JL: What other Emerging Market plays have you been looking at?

CD: One fund I like is Claymore/AlphaShares China Small Cap ETF (NYSEARCA:HAO). This is because Chinese small caps have been much more effective than the large caps there at capturing the market's upside.

Another fund I'm currently bullish on is iShares MSCI Turkey Index ETF (NYSEARCA:TUR) (it's currently 5% of the Emerging Markets portfolio). Turkey is one of cheapest markets out there right now on a trailing P/E basis. Its P/E is literally half that of India's. After a brief period of instability following the recent coup attempt there which saw TUR sell-off 20%, markets have stabilized. This is definitely one of the major risks with Emerging Markets - geopolitical instability.

[As an aside, I prefer to use trailing PEs, going back either 12 months, or even for the most recent quarter annualized over a year, as opposed to forward P/Es when analyzing whether a market is under or overvalued. I find forward P/Es are too speculative to really trust. It is also important to look at price to book and price to sales.]

Next, there's Market Vectors Brazil Small-Cap ETF (NYSEARCA:BRF), which is also 5% of the Emerging Markets portfolio. I chose this over iShares MSCI Brazil Index ETF (NYSEARCA:EWZ) due to its heavier weighting towards Brazil's consumer sector (roughly 40% of its total holdings). EWZ, which is also a great fund, weights materials stocks and financials much more heavily, which is less preferable to me right now.

iShares MSCI South Korea Index ETF (NYSEARCA:EWY) is another fund I'm currently holding. Samsung recently became the biggest tech company in the world. It has a GDP roughly the size of India's with only a fraction of the population. South Korean equities aren't as cheap as they used to be, but it's still a compelling enough value to hold.

Another fund I'm currently recommending is PowerShares Emerging Markets Infrastructure ETF (NYSEARCA:PXR). This fund holds many companies that are based in both developed and emerging countries, with heavy exposure to Emerging infrastructure projects such as Caterpillar (NYSE:CAT), as well as infrastructure plays based in Emerging Markets so it's an interesting blend in terms of that.

JL: Anything you're looking at but have yet to recommend?

CD: Sure. Market Vectors Indonesia Index ETF (NYSEARCA:IDX) is an overlooked market and a good growth story at the moment. It's just a bit pricey right now but if the valuations come down, I'll likely buy.

JL: Within your Emerging Markets portfolio, would you say your main objective is currently capital appreciation, or capital preservation?

CD: Well I'm positioned fairly conservatively at the moment. I have 20% of the portfolio in cash and another 30% in fixed income and currency funds, including 15% in iShares JPMorgan USD Emerging Markets Bond ETF (NYSEARCA:EMB). After the nearly 100% recovery Emerging Markets have had, their direction in the near-term is uncertain so capital preservation is certainly a major goal right now.

In general, I believe proper diversification is the key to being sufficiently defensive as even if one position explodes, it's minimal relative to the overall portfolio size. My goal is not to try and beat the benchmarks every single year. I prefer to take a longer view, preserving capital and beating the market over longer periods of time. Once in a position, I use basic technical indicators like 50- and 200-day moving averages, as well as careful analysis of fundamental valuations to rebalance positions. Ultimately, a lot of the portfolio decisions I make come down to a judgement call that is partly based on intuition which stems from a general knowledge of how these markets and funds have performed in the past.

JL: How about Frontier Market investing - there are several ETF plays available in that area right now?

CD: I am reluctant to venture into these markets and I certainly wouldn't overdo it with them. I generally prefer countries that are members of the MSCI Emerging Markets Index. I have held PowerShares MENA Frontier Countries ETF (NASDAQ:PMNA) and Market Vectors Africa ETF (NYSEARCA:AFK) in the past. I also took a good look at Market Vectors Egypt Index ETF (NYSEARCA:EGPT) when it launched in February. I think it's a nice fund but too pricey at the moment. I'd definitely wait for valuations to come down there. In general, any geopolitical risk that exists with Emerging Markets is magnified with Frontier Markets.

JL: Moving along, how are you playing Developed Markets, via your Global Core portfolio?

CD: One area we're seeing good momentum in at the moment as a result of the recovery is U.S. small caps. I've been playing these via iShares Russell Microcap Index ETF (NYSEARCA:IWC) which invests in companies with markets caps under $600 million.

As a counterweight to that, I am holding iShares S&P Global 100 Index ETF (IOO) which covers the 100 largest companies in the world.

JL: Is there much overlap between IOO's holdings and some of the Emerging Market funds you currently hold?

CD: It's not too bad in terms of overlap. There are a total of 12 Emerging Market-based companies in IOO at the moment. That is actually up from zero Emerging companies four or five years ago.

JL: So conceivably in another 5 years, this fund could have a significant Emerging Markets component to it?

CD: If Emerging Markets continue outperforming developed ones, then definitely.

JL: I see you have 10% of the Global Core portfolio in PowerShares DB US Dollar Index Bullish ETF (NYSEARCA:UUP). Why?

CD: I have been mixing a long position in UUP with ProShares UltraShort Euro ETF (NYSEARCA:EUO), which is a longer term play. The euro is an economic union without a fiscal union backing it. The ECB has no teeth in terms of enacting policy. This doesn't bode well for the strength of the euro long-term. I think we will ultimately reach parity between the euro and dollar. The pendulum has definitely swung back towards the dollar at this point.

JL: How about your Bond allocation?

CD: iShares Lehman 20+ Year Treasury Bond ETF (NYSEARCA:TLT) is currently 15% of the Global Core portfolio. I could see taking a short position via an inverse ETF in the future but I think the Fed will leave rates low for the time being. Not that they shouldn't raise them - it would be nice to see them raise rates marginally as a statement that the worst is behind us but I don't think the Fed will have the guts to do that in the near-term.

JL: Will we see ETFs overtake Mutual Funds in terms of total assets?

CD: ETFs definitely have wind at their back. The major challenge for ETFs right now is education. Even advisors have trouble wading through the more than 900 exchange traded products on the market right now, a number that seems to be growing rapidly. There's a real opportunity out there for people packaging ETF-based portfolios for financial advisors, because the knowledge of these products is still so minimal.

JL: Thanks Carl!