By Patricia Oey
Emerging markets were one of the worst-performing asset classes in 2011, but they are currently in favor with U.S. investors. In the exchange-traded-fund universe, this asset class gained the most net inflows in the first month of the year. On one hand, we like the contrarian discipline many investors are showing. However, it may also be indicative of a sudden willingness to assume greater risk.
In either case, discretion is advised. Survey the landscape of available funds with an eye on both performance and fees. And don't forget to look beyond the two behemoths: The two largest emerging-markets ETFs both track the market-cap-weighted MSCI Emerging Markets Index-- Vanguard MSCI Emerging Markets ETF (VWO) and iShares MSCI Emerging Markets ETF (EEM). While these are great funds, we also have an affinity for a dividend-focused emerging-markets fund that has delivered better risk-adjusted returns relative to its cap weighted peers.
Dividends as Risk Tools
WisdomTree Emerging Markets Equity Income ETF (DEM) is our pick for passive, emerging-markets exposure and is suitable as a small core holding. DEM holds 300 of the highest-dividend-yielding emerging-markets stocks, weighted by annual cash dividends paid, which result in a value-oriented portfolio. Since this fund's mid-2007 inception, it has earned higher absolute and risk-adjusted returns than the market-weighted MSCI Emerging Markets Index. This outperformance, combined with DEM's relatively lower volatility, suggests that a dividend-focused strategy is a viable strategy in emerging markets.
While this fund is significantly less volatile than the MSCI Emerging Markets Index, it is still risky, as emerging-markets equities and currencies can see steep declines when global market volatility is high. DEM, like most ETFs that invest in international equities, does not hedge its foreign-currency exposure, so in a "risk off" environment, emerging-markets investors suffer from both falling asset prices and falling currencies.
We like this ETF's dividend-weighting methodology because it is a straightforward measure of value that is not affected by variances in accounting standards across countries. High-yield stocks have historically outperformed no- and low-yield stocks in most countries studied, a manifestation of the value premium. DEM's dividend strategy may also reduce valuation risk. Historically, high gross-domestic-product growth has predicted low realized stock-market returns, possibly because of investor overoptimism--similar to what has been observed with growth stocks. By anchoring bets to a fundamental valuation measure, value strategies like DEM's may earn excess returns by avoiding overpriced companies and sectors. This ETF usually trades at a lower trailing 12-month P/E ratio relative to the MSCI Emerging Markets Index.
The Market Case
As the developed world continues to face slow growth in the near term, emerging economies should benefit from a number of long-term growth drivers such as new infrastructure construction, higher-value manufacturing and services exports, and rising domestic consumption. And in the near term, most emerging-markets countries have more leeway to adjust their monetary and fiscal policies to support growth, and inflation risks have ebbed. We think the companies in this fund are well positioned to benefit from these trends. Should global volatility recede to more normal levels, we think current low valuations and potential proactive stimulus measures should support improving emerging-markets performance in 2012. In addition, most emerging-markets countries have healthy budgets, high levels of foreign reserves, and attractive growth outlooks and will likely enjoy investment inflows--all of which will likely support appreciating currencies over the long term.
However, there are near-term risks that should not be overlooked. Periods of very high global market uncertainty (such as an escalating eurozone crisis) tend to have an outsized negative impact on emerging markets. In addition, slowing global growth will weigh on emerging markets, many of which are export-oriented economies.
This ETF has heavy weightings in Brazil and Taiwan, each of which account for about 20% of DEM's portfolio. These country weightings are notable because, in the past few years, Brazilian and Taiwanese companies have benefited significantly from their growing exposure to China. So, this fund's 3% weighting in Chinese companies somewhat understates its overall exposure to demand growth in China. At this time, the Chinese government remains committed to maintaining high-single-digit GDP growth, but it will be a difficult balancing act in the near term. With slowing demand from its export markets, China will need to focus on domestic consumption without reflating an asset bubble, maintain control over the yuan exchange rate, and ensure stability in its banking and real estate sector. The China demand tailwind for Taiwanese and Brazilian companies will likely ebb in the near term.
Aside from China, Taiwan companies may be negatively affected by slowing global growth, as exports account for 62% of Taiwan's GDP. However, 50% of this fund's Taiwan holdings are technology firms, which are positioned to capitalize on rising penetration of smartphone and tablet use, especially in the emerging markets. In Brazil, DEM's holdings are mainly in financials, consumer staples, and utility companies. Recently, the Brazilian government has started to move forward with fiscal and monetary stimulus to address slowing growth, which may be a positive for Brazilian markets. In the medium term, planned domestic infrastructure spending ahead of the 2014 World Cup and 2016 Summer Olympics may also provide a boost to Brazil's industrial and material firms, as well as employment and consumer spending.
The Fine Print
DEM tracks the performance of the top 30% highest-dividend-yielding stocks from the WisdomTree Emerging Markets Dividend Index. The stocks are weighted based on annual cash dividends paid (as opposed to dividend yield), tilting the index toward large-value companies.
Investors should note that a portion of this fund's dividends will not be qualified, as the United States has different tax agreements with different countries. (In 2010, 57% of DEM's dividends were considered qualified.) In addition, some of the dividends are subject to foreign tax withholding. (In 2010, about 4% was withheld.) Investors can claim their portion of the withheld taxes as a tax credit, but only if they hold this fund in a taxable account.
Also, this is not the cheapest option available. It charges 0.63% per year, which is bested by two market-cap-weighted emerging-markets ETF choices including Vanguard Emerging Markets Stock ETF (VWO) (expense ratio 0.22%) and Schwab Emerging Markets Equity ETF (SCHE) (0.25%).
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.