Emerging Markets ETFs: Predictable and Consistent

Herb Morgan (Efficient Market Advisors, LLC) submits: Weather and equity markets have a lot in common. Predicting them with consistent accuracy is extraordinarily difficult and “fat tail” performance patterns are regularly reversed in a sudden and ferocious manner.

Just a few short weeks ago people had written off the ski season in the Western Sierras, citing snow fall significantly below the traditional numbers. Unsurprisingly, the “weather market” has corrected the fat tail performance abruptly dumping multiple feet of sweet powder on the slopes over a few short days.

I have been politely criticized by contributors to Seeking Alpha for my decision to exclude all emerging markets ETFs from our client portfolios. Certainly my conservatism has had its opportunity cost over the last few years. In true predictable and consistent form, emerging market ETFs are entering the early stages of a major correction.

Tuesday, 9 exchange traded funds based on emerging Asian markets corrected unsustainable performance patterns triggered by a Shanghai stock market that plummeted nearly 9% overnight:

ETF, Drop
IShares:FTSE/Xinhua (FXI), -9.9%
PowerShares Golden Dragon ETF (PGJ), -9.6%
IShares MSCI Emerging Market ETF (EEM), -8.1%
Vanguard Emerging Markets ETF (VWO), -7.3%
IShares MSCI Hong Kong Index Fund (EWH), -7.4%
iShares MSCI Taiwan Index Fund (EWT), -6%
iShares MSCI South Korea Index Fund (EWY), -6.4%
iShares MSCI Singapore Index Fund (EWS), -7.8%
iShares MSCI Malaysia Index Fund (EWM), -9%

My rejection of emerging markets for our client portfolios was never based on a disbelief in the expansion of economic activity in the region but rather on a firm conviction of the ability of such markets to deliver sudden and seemingly unexpected corrections. It remains my position that emerging markets present a disfavorable risk reward relationship and that further weakening can be expected in the near term.

Comments

[PINAKi DASG...:]

well the emerging mkt. were cuaght on the web of 9... chinese new year started on feb 18th 2007 .. the year for pig.. 18=9 & 2007 =9 numerology mars / fire element ... year of pig signifies fire and water .. water in chinese fengshui attracts wealth and fire burns it away..

"Pig years can be turbulent because they are dominated by fire and water, conflicting elements that tend to cause havoc,Raymond Lo(fengshui expert) said.

"Fire sitting on water is a symbol of conflict and skirmish," he said. "We'll also see more fire disasters and bombings." China is showing the way...as the water and fire battle it out..and combines to form steam( overheated (fire)speculative market combining with cooler water to form gas) volatility will be up and down this year...( classic brownian motion) also pig came in last 12th in the race to lord buddha hence the last year in the 12 year cycle. 12th house in hindu astrology signifies house of losses/redemption/repe... /let go/hospitals etc...... which shld signify bearish outlook through out this year. so go putting(options).. did I say play golf ??

surprising how one sneeze in china affects global mkts and economy."Tuesday, 9 exchange traded funds based on emerging Asian markets corrected unsustainable performance patterns triggered by a Shanghai stock market that plummeted nearly 9% overnight: ETF, Drop IShares:FTSE/Xinhua (NYSE: FXI - News) -9.9%" you see how number 9 is omnipresent !!!! ....

Sadly, so that is harbinger of things to come.. i know i don't sound too optimistic.. but as US economy is slowing down , i still don't think the bear market has not set in as YET...

2007 Feb 28 09:33 AM

[Silly Wabbit:]

Herb Morgan's Seeking Alpha article about not being in Emerging Markets is more a case
of a broken clock being right twice a day. The reality is even if you got in FXI, PGJ,
EWM, EWS & EWH JUST BEFORE the last downturn in May 2006, you'd STILL be making
money now (although a lot less after yesterday's drop). The other 4 are at breakeven.
Like Casey Stengel used to say, you can look it up!

Moreover, everything got hit. You could not avoid the fall (US or globally) unless you
were totally in cash.

As far as the future, who knows for sure? But we do know the P/E of these ETFs are
reasonable, even cheap. And the precipitating factor has apparently been erased
(apparently the Chinese government wouldn't impose capital-gains taxes on stocks).

As for PINAKi DASGUPTA's comments, I sure hope you aren't managing anyone's money.

2007 Feb 28 10:29 AM

[Silly Wabbit:]

I should add that I do own VWO, but I don't own any of the others.

2007 Feb 28 10:31 AM

[PINAKi DASG...:]

As for your comments , I do hope the same for you.I do appreciate your optimism though, Yes, even after the last week tuesday's decline these ETFs will still be making money,because of the fantastic growth ( shanghai index130% in 2006) have had in the recent past, but the point is the emerging markets are now under increasing pressure to measure upto the same level of optimism they had once showed and are nearing the end of their performance cycle.
(to quote Tom Lyndon 8th march article:"Emerging markets ETFs had a rough week, but Russia seemed to be one of the hardest hit.This makes Russia the worst performer year-to-date among major global benchmarks.

Polya Lesova of MarketWatch.com adds that Falling commodity prices, particularly oils and metal, added to a rush to reduce global risk exposure. This put pressure on the Russian market as well as other emerging markets which tend to have a commodity-driven economy. Other BRIC countries, India, China and Brazil, remain under heavy selling pressure. Insiders to the industry say this market sell-off is following in the patterns of the five previous corrections since 2003.")

The technicalities of P/E or P/E (forward) or PEG does little to calm the investors confidence or hope , when panic/fear grips in.. one rumor is enough to trigger a domino effect. The ETFs being cheap is relative ,varies from investor to investor, although they are cheaper now than last year.

2007 Mar 08 06:38 PM

[ETF Wanderer_:]

Essentially, these days there are just "pure" asset classes - all things correlated to equities and all things correlated to bonds.

There is no such thing as emerging market as a different asset class. Even commodities, currency carry trades etc are correlated with equities these days. unless you were in bonds, there is nothing that could have saved you from yesterday's crash.

US market is just a relatively low vol version of an equity market. Just like if you pick up any index, it will have some low vol relative to the index and some high vol relative to the index; similarly on a world equity market, us & emerging markets differ on just the vols.

As far as risk-reward characteristics are concerned, emerging markets have had too high returns that they will compensate adequate for any risk, including yesterday's crash.

2007 Feb 28 12:47 PM

[David Jackson:]

ETF Wanderer, I've edited your comment to remove the inflammatory (and unnecessary) language. Please remember the ground rules for commenting on Seeking Alpha: you can criticise articles and ideas, but may not attack or in any way insult individuals.

2007 Feb 28 06:36 PM

[ETF Wanderer_:]

Sorry about that. Just that the article seemed a bit too unintelligent. It is not an article worth putting in the same league as the Seekingalpha articles such by other etf writers such as those by Roger, Tom Lyndon, Megane etc.

2007 Mar 01 10:35 PM

[David Jackson:]

Herb is making a substantive point: that emerging market ETFs are more volatile than is appropriate for many portfolios, and are at the late stage in their performance cycle. Those are points that you should dispute directly, not in the form of questioning his motivation, integrity or intelligence. (You did that again in your reply to my comment, so I've had to cut that sentence out!).

The level of discussion on Seeking Alpha is outstanding because we're careful to avoid the mud-slinging that plagues many large message boards, destroying their usefulness. Please be extremely careful about this in future -- we hate removing readers' right to comment.

2007 Mar 02 05:54 AM

[Chamois16:]

Volatility, common to emerging markets, is not a reason to exclude individual securities, including ETF; longer term performance of all these funds you mention, with the possible exception of PGJ, which at best is a managed fund in drag, exceeds that of most developed markets. They had become overbought, but still represent long term value, particularly after correction

Excess volatility at the portfolio level is to be avoided since it represents risk, but a properly diversified portfolio will handle, and benefit from, emerging market stocks and index funds.

2007 Feb 28 01:26 PM

[Jeff Maslan:]

If Mr Morgan avoids investing in these funds because of 10% drops every now and then, he is missing out on one of the most profitable sectors in ETF's. In the last 13 - 16 months, I am up 49% to 38% in FXI, EEM, VWO, EWS and EWM - after a 10% drop (followed up by a 4% gain today). All of my emerging market ETF's have had amazing returns - and now, after the drop - are poised to keep on going. This happened last May, and short sighted investors were saying the same thing. These ETF's have produced big returns steadily year after year. Mr Morgan, please stay on the sideline, so you can sleep better with middling results. The rest of us "fearless" investors will be happy to make all the money you are passing on.

2007 Feb 28 07:01 PM

[Geoff Consi...:]

This is an odd discussion for an audience as (generally) smart as SA. We have have known forever that emerging markets are higher risk and higher return than domestic equity markets. This is not good or bad--it just is. There are people and portfolios that will not benefit by adding more than a small allocation to these markets--it all depends on your goals and horizon. To say unequivocally that emerging markets are too risky does not add value to a discussion. Neither does it add value to say that these markets have generated tons of return over the last several years and that people who are sitting out are fools--that argument was used during the tech bubble and we all know how that turned out. Emerging markets are a high risk / high return proposition. They are also (often) quite highly correlated to domestic equity markets, so they are not much of a hedge.

2007 Mar 02 01:09 PM