Is Emerging Market ETF Slicing and Dicing Necessary?

In the past, I’ve commented on how a Canadian investor should not consider emerging market investments, in general, as a diversifier to their total portfolio. If in fact they do have a home bias, as most investors do, the results during times of distress can be quite agonizing. Not only are the correlation in returns high between Canada (EWC) and the emerging markets, but they are the perfect anti-diversifiers:

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The same is true for other resource heavy economies such as Australia (EWA):

And South Africa (EZA):

Interesting that in this last case we see that the South African ETF is actually more volatile than EEM but that isn’t surprising when you see that nearly 25% of the fund is in the metals and mining sector.

Based on the above, it’s fair to assume that this correlation risk can be applied to any investor with a relatively large exposure to the commodity complex, no matter where they are located. However, you don’t simply want to avoid the greater macro story coming out of the developing world, do you? We need to think about what other possible choices there are beyond broad EM exposures such as EEM and VWO.

Latin America

Let’s take a look at these ETFs for the Latin America region:

Again, I use the same 3-year timeframe as the charts above. Probably not surprisingly, we see that the broad Latin American ETF (ILF) zigs and zags in tandem with the Mexican ETF (EWW) and Brazilian ETF (EWZ). Suddenly, EEM looks conservative in comparison to these but follows the same upwards and downward oscillations. The correlations are to be carefully considered if you hold some (or all!) of these.

East Asia

Here we finally see some variation in price movement, in this case from the far east:

The Malaysian (EWM) and Taiwanese (EWT) ETFs seem to move closest together. China (FXI) and South Korea (EWY) show great appreciation but at different times. However, what we find again is the synchronized down movements not only in the summer of 2006 but in March and October of 2005. Scroll up to review all the other charts and you’ll see that when I say “synchronized”, it’s global in scope.

Central/Eastern Europe

What about this region? We don’t have an ETF for this region yet although Roger Nusbaum discussed a new index that could be easily tracked by an ETF … but c’mon, 15 stocks! Bogle will go bananas over this.

So, I dig into the closed end fund world to build this chart which has the Central Europe & Russia Fund (CEE), Morgan Stanley Eastern Europe Fund (RNE) and the Templeton Russia & East European Fund (TRF):

Same moments of downward movement as described above, and then some. No doubt investors in this region experienced a “Maalox moment” last summer.

So, we can see that within each region there’s quite a bit of correlation, but especially during times of significant market distress where, in fact, the correlation is not just high within that region but within what looks like all emerging markets. What about the BRICs?

Although we have news of Van Eck soon to launch a Russian ETF, the best I can do for charting Russia is ING Funds’ Russia Fund [LETRX]. Similarly with India, the iPath MSCI India Index Exchange Traded Notes (INP) from Barclays does not have a long track record like The India Fund (IFN) which I use in its place.

The chart only goes back 2 years because of the shorter record for FXI. However, the real problem with this chart is that we have a mix of indexing and active management. For example, someone else may have chosen another proxy for India, such as the Eaton Vance Greater India Fund [EMGIX] and the results would be significantly different from IFN as shown in this 12-month chart:

But I think the point is that if you have regional emerging market exposures as shown with the BRIC exposures from the 2nd chart up, you’re getting about as good an amount of diversification as you can get … still getting the upside boost of these regions’ returns but also with the coordinated downside which it seems you can’t escape without some serious timing abilities.

Whether you call it timing or active management, it seems as if it is required for the emerging market space. And I say this despite the fact that the SPIVA scorecards from Standard and Poor’s show that active managers in even this space have a difficult time beating their relevant benchmark. Nevertheless, you either rely on some timing or else you’ll have to accept some serious drawdowns like we saw last summer as part of the plan.

I specifically chose some funds above from the individual BRIC countries but of them, it’s nice to see that it’s the big newsmakers, China and India, that show somewhat reduced levels of correlated returns:

To me, it’s unfortunate that Brazil’s weighting is so large in BRIC ETFs (nearly half) with China, and especially India, with smaller allocations. Thus, I like the idea of country specific ETFs for China and India as well as the idea of a Chindia ETF. Some news here about an upcoming ETF for this combination.

For the future, emerging markets, but especially China and India, are the real stories. If I were consulting on a hedge fund mandate related to these regions (which I’m currently not), the problem I’d focus on would not be the long exposures but the ability to be opportunistic on the short side. Based on the charts above, the down periods can be short but painful. However, it’s important to note that these are not just emerging economic markets but emerging securities markets. Thus, the regulatory environment does not often allow for easy and opportunistic trading. You will often have a tough time shorting stocks in these new jurisdictions. A combination of stock selection on the long side (bottom up analysis) with shorting of ETFs (top down analysis)? Sounds pretty basic but this may be the real value of emerging market focused ETFs.