Emerging Markets: Performance-Chasing, Rebalancing And A Better Way To Index

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Includes: DEM, DGS, EEM, EWX
by: Lawrence Weinman

January fund flow data reported that in the first month of 2012, emerging-markets mutual funds took in $2.7bln in assets, while US domestic equity funds showed an outflow of $1.8 billion. Emerging markets ETFs took in $4.7 billion, the largest inflows since October 2010.

Over the past 10 years, emerging markets have returned 15% annually, versus just 3.5% for the S&P 500. That means an equity portfolio with a 30% allocation to Emerging Market Stocks and the rest in the S&P 500 would have returned 2x the return of an allocation 100% in S&P 500. But how many investors actually captured that performance.

As seen by the January inflow numbers, emerging markets are perhaps the sector most prone to performance chasing with investors missing out on the long term returns by selling in panic near the lows and buying late into the rallies. The wild swings in emerging markets are not for the faint of heart, those that underestimate their risk tolerance when putting money into this asset class inevitably wind up selling at precisely the wrong times.

Over the past 10 years while the MSCI Emerging Markets Index (NYSEARCA:EEM) produced a total return of 320% (more than tripling the investors' initial investment) but it was certainly not an investment for the faint of heart. The index experienced a 12 month period with a decline of 56% (Dec 2007- November 2008) and a period with a 92% gain (March 2009 - Feb 2010). Quite a test for the risk tolerance of any investor.

But it is precisely these wide swings that offer so many opportunities for long term investors who include rebalancing in their strategy and choose an allocation to emerging markets appropriate to their risk tolerance. The large swings mean that there is opportunity to earn the "rebalancing premium" by trimming back on positions which grow above the target allocation and buying when large declines make the emerging market stocks underweight compared to target allocation.

Consider the investor with an emerging market target allocation at the end of last year. With emerging markets (NYSEARCA:VWO) down 19.8% in 2011 a rebalancing asset allocator would have been adding to his emerging market position at year end, before the performance chasers jumped in and bought in as VWO jumped 16.5% since Jan 1.

A Better Way to Passively Invest in Emerging Markets

The shortcomings of simple capitalization weighted indexing (I call it first generation indexing) are well known. This type of indexing leads to an overweighting of the stocks with the highest valuation. The indices gradually become large cap growth indices.

Long term research has shown that value stocks generally and small cap value stocks in particular have better risk/return characteristics. Hence the advantage to "fundamental indices" all of which end up with a larger allocation to small cap and value stocks. The methodologies differ with some weighting by dividends, others by price/book, price/earnings or a combination. I'll leave a debate on the methodologies to others at this point. But suffice it to say there is considerable merit to "tilting" a passive portfolio away from capitalization weighting and towards small and value.

The data is pretty clear on this point in the US markets and investors have a wide range of ETFs to implement such a strategy. There seems little reason to think that the same advantage doesn't show itself in foreign markets, and academic research has shown that to be the case.

And it's not just academic research. Dimensional Fund Advisors a pioneer in passively managed investing has had value and small cap emerging market funds up and running for more than a decade. Not surprisingly to those that follow the research regarding small and value premium; the results have been impressive.

The DFA funds are only available to investors who work with a limited group of investment advisors. But there are some ETFs that offer a way to "fundamentally index" in emerging markets. The DFA funds have a track record of over 10 years. The data not only show a performance advantage to the small cap and value weighting but looking at the standard deviation show that the extra return more than offsets any increase in that risk measurement.

Accessing Emerging Markets, Small, and Value through ETFs

The ETFs structured to capture the small and value premium are relatively new but show potential to enhance returns and diversification. In the small cap area there is the SPDR (NYSEARCA:EWX) and (NYSEARCA:DGS) from Wisdomtree. As noted the dividend methodology functions as a value screen so DGS might be seen as small value. Three year data is available for these ETFs. Although the DFA fund outperforms the ETFs all three show an improvement in returns vs. the cap weighted EEM.

The dividend screen used by Wisdomtree is essentially a form of value weighting. Thus the Wisdomtree emerging markets income ETF (NYSEARCA:DEM) captures some of the value premium. Once again the Wisdomtree ETF shows an advantage over the cap weighted EEM but underperforms the DFA fund. Another ETF aimed at emerging markets value EMVX has a very short track record of a little over one year but might merit consideration as an alternative choice in this asset class.

Here is annualized and total return data for the capitalization weighted MSCI Index (EEM targets that index) and some small and value weighted funds and ETFs.

FUND/ETF

3yr

5yr

10 yr

10 yr total return

std dev

MSCI Emerging Markets Cap Wtd

27.9%

5.2%

15.3%

320.0%

26.0%

DFA EM MKt Small Cap (DEMSX)

39.0%

6.6%

18.2%

439.9%

26.2%

Wisdomtree EM Small Cap

32.8%

n/a

n/a

n/a

n/a

SPDR EM Small Cap

32.2%

n/a

n/a

n/a

n/a

DFA EM MKt Value

34.1%

5.6%

19.1%

481.0%

28.5%

Wisdomtree EM Income

31.5%

n/a

n/a

n/a

n/a

With large inflows often rushing into the cap weighted EM ETFs -- VWO and EEM -- it might make sense for EM investors to implement the "second generation' indexing/passive investment strategy of "tilting" to small and value (fundamental indexing) in emerging markets as well. And as always selecting an allocation to match risk tolerance and using rebalancing as opposed to performance chasing are essential to long term investing success.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Mr Weinman's clients have positions in VWO, EEM, DFEVX and DEMSX