Emerging Market Countries: Properly Priced Probabilities

by: Lowell Herr

When adding emerging markets as an asset class to a portfolio, it is natural to gravitate toward either iShares' EEM or Vanguard's VWO. Both ETFs provide broad coverage of emerging markets. For larger portfolios, a manager may want to branch into individual countries.

But what country, and is there a method to test to see when the price may be suitable for entrance? Below is a data table showing 11 individual countries with three years of data. More than 10 countries were eliminated as they did not have sufficient data for analysis. In addition to the 11, EEM is included as one baseline and VWO is selected as the reference ETF. We could as easily have used EEM as the reference.

What the following analysis does is take the historical performance over the last three years and compare it with the projected return for the next year. Delta is the difference between these two values. Take Chile as an example: While Morningstar ranks it as a 5-Star ETF, both the Delta (-9.0%) and Delta Index project a Sell. Delta Index, using probability and reversion-to-the-mean analysis, is warning investors to avoid this ETF.

Delta Index is a proprietary probability calculation that not only is a projection of how well the individual country is expected to perform over the next years, but also how well the performance will rate compared to the broad emerging market ((NYSEARCA:VWO)) ETF. VWO, as already noted, is our frame of reference. Based on this probability analysis, the ETFs with better than average performance will come from BRICs (NYSEARCA:BKF) and Latin America (NYSEARCA:ILF). If one combined Morningstar and Delta Index, then Latin America is the best choice.

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Over the next few months, several more individual countries will qualify for analyis. There are a few very promising Far East countries that should perform well using this type of analysis.

Disclaimer: Caution is in order any time one is extrapolating data. The above analysis does just that as future projections are intimately involved in the Delta Index calculation. Therefore, investors need to do their own careful analysis when it comes to adding individual emerging market countries to their portfolios.

Disclosure: I am long EEM, VWO.