For this article I will be constructing a portfolio of solely Emerging Market ETF's. For the portfolio I have one major goal and that is to minimize the volatility of portfolio, by choosing the lowest volatile ETF's and then weighting each ETF in the portfolio by its volatility. For my fund selection process I will be using the Fidelity ETF Screener. For the portfolio I will include 4 ETF's a Large Cap Emerging Markets fund, a Mid or Small Cap fund, a Emerging Markets Bonds fund, and finally I will include a Inverse Emerging Markets Fund to hedge downside risk in Emerging Markets.
For the two Equity Funds I used the following criteria:
- ETF Type= ETF
- Assets > $50 Million
- Geography=Emerging Markets
- Asset Class=Equity
- Capitalization objective=Large Cap/ Broad
- Dividend Yield > 1%
- 1 year Standard Deviation
Large Cap Emerging Markets ETF Selection
There were 18 ETF's that met the above Criteria, and the one with the lowest standard deviation was the WisdomTree Emerging Markets Equity Inc (DEM), so I included it in the portfolio.
Mid/Small Cap Emerging Markets ETF Selection
After changing the capitalization objective to include only Small and Mid Cap ETF's I found that only 2 ETF's met the criteria and the one with the lowest standard deviation was the WisdomTree Emerging Markets Small Cap Div (DGS), so I included it in the portfolio.
Inverse Emerging Markets ETF Selection
I changed the criteria above to find the ETF for this selection by including only inverse ETF's and removing the capitalization and dividend criteria, I found three ETF's that are inverse Emerging Markets ETF's and there was only one that was Non-leveraged which was the ProShares Short MSCI Emerging Markets (EUM), so I included it in the portfolio.
Emerging Markets Bond ETF Selection
For this selection I changed the Asset Class to Fixed Income and removed the capitalization objective from the criteria above and found that 6 ETF's met the criteria and the one with the lowest standard deviation was the PowerShares Emerging Markets Sovereign Debt (PCY), so I included it in the portfolio.
Data & Charts
Below is a table showing each fund with weight and volatility as well as charts comparing the portfolio to the biggest Emerging Markets ETF which is the Vanguard MSCI Emerging Markets ETF (VWO). For the volatility data I will be using the 3 month volatility over the last 12 months from the ETFreplay.com Volatility tool, and data from the charts and return tables are from the ETFreplay.com backtest tool.
|PCY||PowerShares Emerging Mkts Sovereign Debt||35%||5.20%|
|DEM||WisdomTree Emerging Markets Equity Inc||30%||18.00%|
|DGS||WisdomTree Emerging Mkts Small Cap Div||25%||18.60%|
|EUM||ProShares Short MSCI Emerging Markets||10%||22.40%|
As the charts above show the portfolio over the available data period outperformed VWO by a wide margin, which I did expect because of the large allocation to bonds, and the EUM hedge. The third chart shows that for 4 out of the last six years the portfolio has outperformed VWO, and the two years it did not was the recovery off the stock market bottom in 2009 into 2010. Also, something else I noticed was that the portfolio achieved the return it did with around 60% less volatility than VWO, which shows the affects of having a fixed income fund in the portfolio, as well as weighting the portfolio by volatility, and selecting the individual funds compared to their peers by volatility. The reason behind having a portfolio of only Emerging Market ETF's is the theory of investing where the growth is, even if it is slowing growth the growth in Emerging Markets is much greatly than that of the U.S, and Europe.
Some of the challenges of this portfolio would be putting all your investment eggs in the Emerging Markets basket, and not diversifying into other countries or asset classes. But if you have a growth focus, Emerging Markets is where the growth is at. Another risk is the volatility, on average the volatility in Emerging Markets ETF's are greater than that of Large Cap US ETF's for example, comparing the SPDR S&P 500 (SPY) and VWO using the volatility tool it is easy to see, and it shows SPY volatility of 15.4% and VWO volatility at 21.2% so the VWO volatility is about 40% more than that of SPY.
Disclosure: I am long EUM.