With the conventional risk-free rate of return pegged at zero by way of the federal funds rate, investment interest in emerging market securities and other "risk assets" continues to be strong. While flows into some asset classes-- like the relatively illiquid floating rate space-- may represent a desperate reach for yield in anticipation of inflation and rising interest rates, the growth prospects of many emerging economies justify strong flows.
Generally speaking, emerging economies have relatively low external debt levels and household debt levels because consumers have not had access to credit cards or home equity lines. Households also exhibit a propensity for saving, in some cases as high as 50% of income, encouraged by the lack of social safety nets like unemployment insurance, medicare, and social security. As is painfully evident in the developed world, high external and household debt levels and low personal savings rates strangle growth. Therefore it is reasonable to expect relative out performance from emerging markets, despite growing pains including excessive speculation or "hot money flows."
Investments in emerging markets are not without risk, however, and tend to exhibit high levels of volatility when measured by objective gauges such as standard deviation. Intuitively, this makes sense as these investments are subject to greater political risk and currency risk, as well as issues with improper financial reporting and transparency. Below is a chart of risk statistics comparing the MSCI Emerging Markets Index against U.S. stocks (S&P 500), U.S. bonds (Barclays Aggregate), and international stocks (MSCI EAFE).
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Over the course of the analysis period above, investors in emerging markets were well rewarded. However in light of the risk factors enumerated above, retail investors may be best served to utilize a broadly diversified vehicle like an exchange traded fund. When searching for such a vehicle, first apply a screen that removes the ETFs which do not trade frequently enough. Requiring an average daily volume of 200,000 shares is a good starting point in this space. The second consideration is sector or geographic exposure. Choosing sector or country / region specific ETFs may expose your investment to overly concentrated underlying positions. For example, Petrobras (NYSE:PBR) accounts for more than 11% of the iShares Brazil offering (NYSEARCA:EWZ) and Samsung (OTC:SSNLF) accounts for over 16% of the South Korea offering (NYSEARCA:EWY). Accordingly, eliminate those offerings for the purpose of this article.
This search returns three suitable alternatives to consider; iShares MSCI Emerging Markets Index Fund (NYSEARCA:EEM), Vanguard MSCI Emerging Markets ETF (NYSEARCA:VWO), and WisdomTree Emerging Markets Equity Income Fund (NYSEARCA:DEM). The first two offerings from iShares and Vanguard respectively are designed to track the same index and as such exhibit similar performance over time. For an investor desiring extreme holdings diversification and rock bottom expense, Vanguard's ETF is likely the optimum choice.
|Fund Company||Ticker||Expense Ratio||# of Holdings||Top Country Exposure||Index Tracked|
|iShares||EEM||0.69%||770||China - 17.09%||MSCI Emerging Markets Index|
|Vanguard||VWO||0.22%||897||China - 17.50%||MSCI Emerging Markets Index|
|WisdomTree||DEM||0.63%||268||Taiwan - 18.34%||WisdomTree Emerging Markets Equity Income Index|
The WisdomTree ETF provides a unique perspective on emerging markets stocks with its proprietary index methodology. After initially screening for liquidity requirements, WisdomTree ranks stocks by dividend yield and selects the top 30% for inclusion. In ranking stocks by dividend yield, the fund creates a natural value bias, as growth companies are more likely to reinvest in their business rather than distribute cash to shareholders. This bias historically provided downside protection during periods of volatility while causing the fund to lag its MSCI counterparts during upswings.
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In summary, investors looking for the cheapest and broadest exposure to emerging markets stocks will likely benefit from the use of Vanguard's fund in their portfolios. Value minded investors who are leery of drawdowns and inflationary concerns in China, (which comprises just 3.53% of the index) may prefer WisdomTree's offering.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.