Looking for Value in Emerging Markets With Global X Funds

 |  Includes: DEM, EMGX, EMVX, PXH, VWO
by: David Ott

Ever since Professors Gene Fama and Ken French introduced their three-factor model that demonstrates the persistence of risk premiums in small cap companies and ‘value’ companies, financial services firms have worked hard to create products to fill the related Morningstar Style Box.

Today, there are seven ETF providers that have sliced and diced the domestic large cap universe into 26 ‘growth’ and ‘value’ ETFs. Given the competition in the domestic large cap segment, it makes sense that an ETF provider would search the globe looking to carve up other markets.

Enter Global X, a relatively small but fast-growing ETF provider with approximately $1 billion in assets. Late last month, Global X Funds launched the Russell Emerging Markets Growth (NYSE:EMGX) and Russell Emerging Markets Value (NYSE:EMVX) ETFs. Both funds track indexes created by Russell Investments and date back to 2005.

A number of good articles describe the basic characteristics of the funds, although they don’t evaluate the risk/return characteristics of the backtested data. It’s worth noting that five years isn’t a particularly long data set, and, as Nobel Laureate Bill Sharpe once said, “I’ve never met a backtest I didn’t like.”

For the five years ending Dec. 31, 2010, the Russell Emerging Markets Growth Index returned 12.63% per year with a standard deviation of 29.68%, for a Sharpe Ratio of 0.35. The Russell Emerging Markets Value Index earned 11.17% and had a nearly identical standard deviation of 29.85%, but because of the lower return, only had a Sharpe Ratio of 0.30 for the same time period.

The Vanguard Emerging Markets ETF (NYSEARCA:VWO) returned 11.65% with a standard deviation of 28.71% and a Sharpe Ratio of 0.33.

I was a little surprised to see that the growth index outperformed the value index because the fund that I have used as a benchmark for value in Emerging Markets, the DFA Emerging Markets Value Fund (DFEVX), has done extremely well. Over same five year time period, DFEVX earned a high rate of return of 16.76%, also had higher volatility of 31.21%, but still achieved an attractive Sharpe Ratio of 0.46.

Since my firm isn’t a pure indexer we can’t use DFEVX, so we have sought value in Emerging Markets by investing the WisdomTree Emerging Markets ETF (NYSEARCA:DEM), the dividend-weighted fundamental index. Unfortunately, this particular product has only been available for 41 months and there is no backtest to allow for a full five-year comparison. (Incidentally, DEM has crushed all of the other products mentioned in this article for the 41 months that it has been available.)

However, backtest data is available for a different fundamental index, the RAFI FTSE Emerging Markets index, which is available as an ETF through Powershares (NYSE:PHX). The RAFI index earned an annual rate of return of 14.31% and had a standard deviation of 27.56%, for a Sharpe Ratio of 0.44.

As pleased as I am to see Global X Funds enter the market with a good concept, based on this data, I believe that investors seeking value should look to the fundamental indexing approach to find value in Emerging Markets.

Disclosure: I am long DEM, VWO.

Additional disclosure: The views expressed do not necessarily represent the views of Acropolis Investment Management, LLC. or its members. Clients of Acropolis own ~$11 million of VWO and ~$2 million of DEM as core holdings and we are regularly buying and selling both securities for clients as part of our portfolio rebalancing strategy.