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By Patricia Oey

Investors are dipping back into emerging-markets stocks. In March 2014, flows into diversified emerging-markets open-end funds and exchange-traded funds turned positive after four consecutive months of outflows. Fundamentals in emerging markets have not necessarily improved, but investor sentiment has. According to the Bank of America Merrill Lynch Fund Manager Survey for April, 55% think emerging markets are undervalued, up from 49% in March. More interestingly, only 2% indicated a desire to underweight emerging markets, down sharply from 21% in March.

In reality, most investors are probably underweight emerging markets. Emerging-markets equities (as measured by the MSCI Emerging Markets Index) have been significant underperformers relative to developed-markets equities for the last few years. Those who have not been regularly rebalancing their portfolio will find that they are now a little light on emerging-markets stocks. So, profit-taking in developed-markets equities and portfolio rebalancing are likely two trends that will support flows into emerging markets in the near term.

Within the emerging-markets ETF universe, market-cap-weighted funds have drawn the most inflows of late. This is despite the fact that these funds tend to have significant allocations in global cyclicals and government-controlled firms, which are not the ideal candidates for investors seeking exposure to the anticipated consumer-led growth in developing markets. But what about dividend-oriented ETFs? U.S. equity dividend ETFs are popular core holdings for many investors. Many of these funds employ a number of rules to screen out distressed names, and these ETFs tend to have relatively high-quality portfolios. How well do these rules-based strategies work in emerging markets? Are emerging-markets dividend ETFs suitable for use as a core holding?

It Is Difficult to Apply Strict Quality Screens in Emerging Markets
About 90% of the MSCI Emerging Markets Index's 822 constituents pay a dividend, which means there is a broad pool of dividend payers in the emerging markets. Like their U.S. equity counterparts, emerging-markets dividend ETFs employ rules to try to screen out potential "value traps," distressed firms, and/or lower-quality names. However, because emerging stock markets are not as mature as the U.S. market, many of the common rules used by U.S. dividend ETFs have to be relaxed (market-cap minimums, for example) or even eliminated (consistent dividend growth) when applied to emerging-markets equities. If these rules weren't adjusted, these emerging-markets dividend indexes would have very few constituents.

U.S. equity dividend ETFs that screen for companies that have consistently raised their dividends seem to be successful at filtering out the distressed and deep-value names, as these funds tend to trade at valuation multiples near that of the market-cap-weighted MSCI USA Index (see Figure 1 below). These funds include Vanguard Dividend Appreciation (NYSEARCA:VIG) and SPDR S&P Dividend (NYSEARCA:SDY) (iShares Select Dividend (NYSEARCA:DVY) does not employ this consistent dividend-growth screen). None of the emerging-markets dividend funds employ a dividend-growth screen, and as a result, these funds have much more of a value tilt (see Figure 2). Some of the companies held by these emerging-markets dividend ETFs are trading at low valuation multiples because of an uncertain and evolving regulatory environment--issues that may continue to be an overhang in the medium term.

Figure 1: U.S. Equity Dividend Funds: Holdings-Based Style Trail


Source: Morningstar Direct.

Figure 2: EM Equity Dividend Funds: Holdings-Based Style Trail


Source: Morningstar Direct.

Beware of Country and Sector Concentrations
Using the MSCI Emerging Markets Index as a guide, the emerging markets are a group of around 20 countries scattered around the globe. These economies are more different than they are similar, as each has its own distinct economic and political environment, dividend tax rules, and currency. These differences can have important and unpredictable effects on a rules-based dividend-oriented strategy. First, certain countries (such as Taiwan, Brazil, and South Africa) have laws that support higher dividends, so dividend-oriented funds tend to overweight those countries' stocks. Significant country concentration is a risk, as deteriorating local macroeconomic fundamentals can broadly impact the shares listed in those countries. Second, income can be impacted by fluctuating currencies, as these ETFs do not hedge their foreign-currency exposures. Dividends are paid to these funds in local currencies, but the funds' distributions are paid in U.S. dollars. In 2013, sharp declines in the value of the South African rand (South African stocks typically make up about 10% of dividend-oriented emerging-markets ETFs' portfolios) negatively impacted both the dividend payments and the price performance of the South African holdings in these dividend ETFs.

Other Issues to Note
There are also more-general risks to consider. First, these rules-based funds can see significant changes in country and sector allocations following an index rebalance, which means these ETFs will need more-careful monitoring. Investors may find that the new portfolio allocations are not in line with their investment criteria. Secondly, according to most index providers, Taiwan (typically a 20% allocation) sits at the border between emerging- and developed-markets status. When Taiwan is upgraded to being a developed market, these dividend ETFs could become more risky, as Taiwanese stocks tend be less volatile relative to stocks from other emerging markets.

A Closer Look at the Emerging-Markets Dividend ETFs
The three largest emerging-markets dividend ETFs are WisdomTree Emerging Markets Equity Income (NYSEARCA:DEM), SPDR S&P Emerging Markets Dividend (NYSEARCA:EDIV), and iShares Emerging Markets Dividend (NYSEARCA:DVYE). In the past, I have written about the issues facing the WisdomTree ETF, so here I will focus on the SPDR and iShares funds. I also discussed a relative newcomer--Market Vectors MSCI Emerging Markets Quality Dividend (NYSEARCA:QDEM)--in a recent installment of our Morningstar Minute video series.

EDIV tracks the S&P Emerging Markets Dividend Opportunities Index. This index seeks to create a portfolio of high-yielding emerging-markets stocks. The index caps individual country and sector exposures at 25% to mitigate concentration risk, and it employs minimum liquidity requirements to ensure that the portfolio is investable. The index also employs two (not very rigorous) stability screens--constituents must have positive earnings growth in the trailing three-year period and have generated positive earnings for the last 12 months. Firms that pass these screens are then ranked by dividend yield, and the top 100 are included in the index and weighted by their dividend yield. The index is reconstituted twice a year, in January and July.

An index that seeks the highest-yielding stocks within volatile emerging markets lends itself to a portfolio characterized by high turnover and large changes in country and sector allocations. During the last five years, this index has seen annual turnover average around 80%. Shifts in country allocations are partly driven by valuations. Currently, its allocation to Brazilian stocks is around 20%. This reflects the fact that Brazilian equities are currently trading at relatively low valuations (and hence sport relatively higher dividend yields). Around the time that Brazil's stock market peaked in 2008, this index had almost no Brazilian constituents. In the emerging markets, deep-value names may not only be a byproduct of company-specific issues, they may also land in the bargain bin as a result of significant regulatory or political risks that are often difficult to overcome. For example, traditionally high-yielding Brazilian utilities have been underperforming during the last few years as the Brazilian government has mandated that power producers reduce electricity prices to help support the sluggish economy. As for the index's sector weights, these have historically tended to be more stable. This fund has tended to have an overweighting in the materials (which is very cyclical), telecom services, and utilities industries relative to the MSCI Emerging Markets Index.

iShares Emerging Markets Dividend DVYE, which launched in February 2012, tracks the Dow Jones Emerging Markets Select Dividend Index, which is fairly similar to the index underlying EDIV. Constituents must have generated positive earnings during the last 12 months and must have paid dividends during each of the past three years. Stocks that pass these screens are ranked by dividend yield, and the top 100 are included in the index and are weighted by their dividend yield. No more than 30 stocks can be selected from any single country. Despite the similarity in the rules behind their benchmarks, DVYE and EDIV's portfolio holdings only have about a 50% overlap. This is partly because DVYE's index employs very stringent rules for new additions to help tamp down turnover. During the last five years, the fund's annual turnover (the index is reconstituted annually in December) has averaged around 40%. That said, the leading detractors for DVYE in 2013, such as Brazilian utilities and Turkish holdings (which suffered from a declining Turkish lira), also weighed on EDIV's performance.

There are plenty of solid dividend-paying stocks to be found in emerging markets, and open-end funds that have a manager at the helm can take both a quantitative and qualitative approach to select higher-quality holdings. Dividend ETFs, on the other hand, operate on autopilot. Given the broad mix of countries and many political, economic, and regulatory forces in emerging markets, investors should apply a higher degree of scrutiny to emerging-markets dividend funds before investing.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Be Cautious With Emerging-Markets Dividend ETFs