iShares MSCI Emerging Index Fund (NYSEARCA:EEM) and the lower cost Vanguard Emerging Markets ETF (NYSEARCA:VWO) have been the traditional way of investing or trading emerging markets. Over the last few years other firms have attempted to gain market share from the $100+ billion in assets these ETFs hold. Think about it. If you could design an emerging market ETF that could get only 1% of market share, you could collect a small fee on $1 billion. I get it. The problem is, most of the new ETF offerings are worthless at best. Expensive, duplicative, and dubious design has led to a vote of no confidence for most of the new kids on the block.
Every few weeks a new emerging market ETF is released, and we took a look at one that actually had some value. All I can say is that I was shocked. I want to thank our Managing Principal Nancy Hetrick for pointing this one out. Our firm needs people who can challenge my ideas and make sure we don't drift towards dogma. The Wisdom Tree Emerging Market Small Cap Dividend Fund (NYSEARCA:DGS) was put in the crucible. If we could prove it was indeed worthless, great. If not, it was worthy of our consideration.
First, we need to point out what we were looking for that we couldn't get in EEM or VWO. You don't just hunt around for exotic products with no worldview. Our main concern was the growth rate of China and BRIC countries in general. Europe is the largest buyer of Chinese exports. As volatility globally decreases, we want to increase exposure to equity markets in order to keep risk constant, and that includes a larger allocation to emerging markets.
However, we are concerned about the fundamental risk that Europe will be slower in consumption causing a potential decrease in Chinese exports. This concern infects other BRIC countries. Brazil and India both have stakes in the growth of China. Also, where do you think Russia sells all that oil? Europe is at the top of the list.
We threw down the gauntlet. Could we find an emerging market ETF that didn't have a high concentration in the BRICs, but also had a reasonable correlation to the world indexes? We wanted to address our issue, but not go off the map and invest in Mongolian horse futures. Below you can see DGS addresses the BRIC concentration.
Now that the initial issue has been addressed, we wanted to take it a bit further by addressing dividend yield.
Countries outside of the US have a different cultural attitude regarding dividends. It's widely known that emerging market countries tend to pay a higher dividend yield than their US counterparts. So, you can understand why we were disappointed to see the dividend yield of EEM at 1.82% and VWO at 2.03%. Just so you know, the difference in dividend yield appears to be directly related to the lower expense ratio of VWO, which operates at 0.20% versus EEM, which runs expenses at 0.67%. Our firm prefers VWO for that reason. Keep in mind trading liquidity and short term holding periods need to be considered.
DGS on the other hand has a dividend payout of 3.51%, which is 93% more than EEM. Just to play with some numbers here, DGS is 55% higher than a 10-year treasury and 87% more than (NYSEARCA:SPY). I always warn investors not be lured by high dividends. It is the total return that matters. So, before we hit on the raw return numbers, let's first make sure the volatility is in line with other major index funds.
As you can see from the table below, DGS is about 3% less volatile compared to VWO over the last 30 days and the last 3 years. This is not significant to us, but it's worth noting that it has similar, if not lower volatility to the more popular emerging markets index. Understand that no one would argue that both VWO and DGS have materially higher risk than the S&P 500. While we enjoy a slightly lower volatility with DGS versus VWO, we would not make any adjustments in our own models or allocations to clients. In English, volatility is not different enough for us to treat them as unique assets classes from a risk perspective. It's cold comfort knowing that DGS is slightly less volatile while knowing that we are investing in the most dangerous areas of the world. From a practical standpoint, we can justify using DGS as a proxy for EEM or VWO from a high level perspective.
Current 30-Day Historic Volatility
Mean 30-Day Historic Volatility (3 Year)
Let's wrap this up by looking at return. Below is a 3-year chart overlaying VWO, EEM, and DGS. DGS has outperformed over the 3-year time frame by about 10%. It is also slightly less volatile over time. Furthermore, it has less exposure to BRICs, which is our biggest concern currently. Who knows what it will do going forward, we just wanted to address risk of BRICs.
In conclusion, if you're interested in avoiding BRICs, having a higher dividend yield, and using a niche ETF that has a high correlation to VWO and EEM with slightly less volatility, DGS fits that bill. But remember that you are investing in some of the wildest areas of the world. So tread cautiously and don't expect miracles to happen. You should have a longer-term horizon, which is why we take an interest in DGS. And be prepared to suffer the consequences if DGS does not perform as you would like.
Co-written by Raheel Hirji