Emerging Markets: Time to Ditch the Index

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 |  Includes: ECH, EEM, EPU, EWM, EWT, EWW, EWY, EWZ, EZA, FXI, GXG, IDX, PIN, RSX, THD, TUR
by: TAA For The Masses

Emerging markets are skyrocketing as the dollar drops and investors look outside the U to find growth economies. In the last year, emerging markets have outperformed the S&P by nearly 10%. While this is impressive, equally impressive is that this has been a long term trend. Going back a decade to January 2000, we see that emerging markets delivered a 185% total return while the S&P had a negative 6% total return (data courtesy of StockCharts here).

But this is not about the power of emerging markets and why a diversified portfolio should include a healthy slice of emerging markets in a 'new normal' era. Rather, let's look at the index itself see how one might amplify risk adjusted returns even further.

Decomposing the MSCI Index into its country subcomponents (thanks to country ETFs this is very easy), we find two anomalies: Returns on the smaller subcomponents of the index have greatly outperformed the index and the volatility on these smaller components is often no worse or only slightly above the index itself (Chile, for instance, has about the same volatility as 20-30 year US Treasuries!)

Country

Weights in MSCI (as of June '10)

ETF

12m Stn Dev (based on monthly returns)

3m Total Return (from Aug 1)

6m Total Return (from May 1)

12m Total Return (from Nov 1

Avg

Peru

0.76%

EPU

23.24%

37%

41%

56%

45%

Thailand

1.53%

THD

25.11%

28%

40%

68%

45%

Columbia

0.47%

GXG

19.34%

20%

40%

71%

44%

Chile

1.89%

ECH

14.93%

20%

33%

56%

36%

Turkey

1.47%

TUR

36.45%

23%

24%

60%

36%

Indonesia

2.79%

IDX

23.40%

14%

20%

61%

32%

South Africa

7.78%

EZA

28.45%

16%

17%

38%

24%

India

7.23%

PIN

24.55%

17%

16%

36%

23%

Malaysia

2.14%

EWM

14.83%

14%

17%

36%

22%

Brazil

15.20%

EWZ

30.23%

14%

11%

21%

16%

Korea

13.10%

EWY

27.35%

13%

7%

30%

16%

Mexico

4.59%

EWW

21.93%

10%

6%

30%

15%

China

19.08%

FXI

18.91%

11%

14%

12%

12%

Taiwan

10.41%

EWT

24.02%

10%

7%

19%

12%

Russia

6.09%

RSX

24.45%

8%

1%

23%

11%

Index

N/A

EEM

23.59

13%

11%

26%

17%

Click to enlarge

Please note that I purposely do not show Hungary, Philippines, Poland, Czech Republic or Egypt as the ETFs are either (a) too new or (b) do not exist.

Looking at the above chart and rank ordering the ETFs by the average of 3m, 6m, and 12m returns, the data speaks for itself. We have to go down to the 7th ranked ETF until we find a major component of the MSCI index (South Africa). A simple portfolio of picking the top 6 has returned 62%, whereas the index returns just 26% while holding less then 9% of the MSCI index. Additionally, looking at the standard deviations, only one fund (Turkey) had a greater standard deviation than the index. Is this really a free lunch?

Unfortunately, the country ETFs have not been around long enough to do a detailed analysis to whether this is a long term anomaly or just a short term trend that will reverse. Also, some of the country ETFs suffer from low volume and horrendous bid/ask spreads, so we recommend that investors look closely at the ETFs to ensure that the liquidity profile matches their risk tolerance. In any event, we feel confident that exploiting momentum in the individual countries versus the index will continue to provide better risk adjusted returns, even if that means the momentum will shift back to the larger MSCI components. We will continue to monitor these trends at our site and watch for that shift to happen. In the meantime we are excited about these smaller countries.

Disclosure: Author holds position in a majority of the ETFs mentioned in this article