- Emerging market equities offer investors cheap valuations, strong growth prospects, and potential market-beating returns.
- VWO is a particularly simple, cheap, and effective emerging market equities index ETF.
- An overview of the fund follows.
- This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »
Author's note: This article was released to CEF/ETF Income Laboratory members on November 22nd, 2021.
Emerging market equities offer investors comparatively cheap valuations, due to bearish market sentiment, and due to the sky-high valuations sported by most U.S. equities. Emerging market equities also offer investors strong growth prospects, due to a receding pandemic, and elevated commodity prices. Strong growth prospects combined with cheap valuations are a recipe for market-beating returns, in my opinion at least.
The Vanguard FTSE Emerging Markets ETF (NYSEARCA:VWO) is a simple, broad-based, low-cost, emerging markets index ETF. VWO's diversified holdings, cheap valuation, and strong growth prospects make the fund a buy. With a 2.3% dividend yield and lackluster dividend growth, the fund is not an appropriate income vehicle. The iShares Emerging Markets Dividend ETF (DVYE) offers investors emerging market equity exposure and a strong 7.0% dividend yield, and might be a better choice for income investors and retirees.
- Sponsor: Vanguard
- Underlying Index: FTSE Emerging Markets All Cap China A Inclusion Index
- Dividend yield: 2.28%
- Expense ratio: 0.10%
- Total Returns 10Y: 5.78%
VWO Investment Thesis
VWO is a simple, broad-based, low-cost, emerging markets index ETF. VWO's investment thesis rests on the fund's:
- Diversified holdings, which provide investors with all the necessary emerging market equity exposure they could need, and reduce portfolio risk and volatility.
- Cheap valuation and price, which could lead to strong, market-beating returns in the coming months and years.
- Strong growth prospects, due to improved economic fundamentals amid a waning pandemic.
The above combine to create a strong fund and investment opportunity, although a relatively risky one. Let's have a look at each of the points above.
VWO is an index ETF focusing on emerging market equities. It is administered by Vanguard, the second-largest investment manager in the world, and the preeminent index fund providers in the same. Long-time readers know Vanguard is my top choice for cheap index funds, and VWO is no exception.
VWO tracks the FTSE Emerging Markets All Cap China A Inclusion Index, an index of these same securities. It is a relatively simple index, investing in all emerging market equities which meet a basic set of liquidity, trading, and size criteria. The fund includes investments in Chinese A-shares, which are sometimes off-limits to foreign investors. It is a float-adjusted market-capitalization index.
VWO's underlying index is remarkably broad, which results in an incredibly well-diversified fund. VWO invests 5250 securities, and has exposure to most relevant industry segments and emerging market countries. The fund is somewhat overweight China, due to the size of the country's economy and corporate sector. I would have preferred a smaller allocation to China, due to the country's ongoing real estate bubble / crash, but a hefty Chinese allocation is common for emerging market funds, and mostly appropriate. Investors looking for emerging market funds but concerned about Chinese stocks should consider investing in the iShares MSCI Emerging Markets ex China ETF (EMXC) instead. I last covered EMXC here.
The fund is also somewhat overweight financials, a particularly large, important corporate sector in most emerging markets. VWO is, surprisingly, not underweight tech, which is somewhat rare for an international fund. VWO's tech holdings include most of the Asian tech giants, including Taiwan Semiconductor (TSM), Tencent (OTCPK:TCEHY), and Alibaba (BABA). I think that the fund's inclusion of these securities is a significant benefit for shareholders, as these are some of the strongest, fastest growing companies on the planet, and are not included in most US-centric equity index funds. Their inclusion therefore boosts portfolio diversification and potential shareholder returns, a solid combination.
VWO's exposures and holdings are as follows.
VWO's diversified holdings serve to reduce portfolio risk and volatility, a significant benefit for the fund and its shareholders, and a must for a fund investing in risky securities like emerging market equities.
Emerging market equities have been one of the worst-performing asset classes of the past few years. Underperformance has been due to bearish market sentiment, a strong dollar (these securities are either denominated or earn their revenues and earnings in local currencies), and the coronavirus pandemic. VWO itself has significantly underperformed most broad-based U.S. equity indexes for the past few years, and by quite a large margin.
VWO's underperformance was quite obviously detrimental to the fund's past shareholders, but presents something of an opportunity for future and prospective investors. Price weakness almost always means cheap valuations, and that is definitely the case for VWO. The fund sports a PE ratio of 13.3x, and a PB ratio of 2.2x, quite a bit lower than that of most broad-based equity indexes, US or otherwise.
(Source: Vanguard Corporate Website - Chart by author)
Although U.S. equities are generally more expensive than international stocks, the valuation gap is rarely this large, at least according to J.P. Morgan data and calculations.
(Source: J.P. Morgan Guide to the Markets)
VWO's cheap valuation could lead to strong, market-beating returns if market sentiment were to improve, and valuations were to normalize. I believe this is very likely, due to the strong growth prospects of most emerging market economies. Let's have a look.
Strong Growth Prospects
Emerging markets have seen very strong economic growth these past few quarters, due to a receding pandemic, and higher commodity prices. Growth is likely to accelerate in 2022, due to continued mass vaccination drives, the gradual removal of most social distancing measures and regulations, and still-elevated commodity prices. Strong economic growth should lead to even stronger corporate earnings growth, as corporations recover from their pandemic losses. J.P. Morgan is estimating 55% corporate earnings growth for most emerging market companies in 2021, quite a bit higher than average. Growth is likely to be strong in 2022 too, due to the aforementioned reasons.
(Source: J.P. Morgan Guide to the Markets)
Strong earnings growth should act as a catalyst for improved market sentiment, ultimately resulting in higher share prices and market-beating returns for VWO and its shareholders, in my opinion at least.
Risks and Negatives
VWO is a strong fund and investment opportunity, but it is not one without risks and negatives. Two stand out.
First is the fact that emerging market equities tend to be comparatively risky securities, due to political, currency, and economic risk. As such, VWO's investors should expect some underperformance during downturns and recessions, as was the case during 1Q2020, the onset of the coronavirus pandemic. VWO only slightly underperformed during said time period, so I don't see the fund as an excessively risky choice or investment.
Second is the fact that emerging market equities have underperformed most other equity sub-asset classes for decades, and so has VWO. The difference in performance is stark.
(Source: ETF.com - Chart by author)
Importantly, emerging market equities had actually started to perform reasonably well from late 2018 and onwards, only to underperform in early 2021.
Although there are several reasonable reasons for emerging markets to underperform in 2021, including Chinese economic issues and bearish market sentiment, I believe that improved economic fundamentals will soon reverse this trend. Markets can't defy fundamentals forever. Still, investors need to be aware of the underperformance of emerging market equities and VWO.
Conclusion - Buy
VWO's diversified holdings, cheap valuation, and strong growth prospects make the fund a buy.
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This article was written by
Juan de la Hoz has worked as a fixed income trader, financial analyst, operations analyst, and as an economics professor. He has experience analyzing, trading, and negotiating fixed-income securities, including bonds, money markets, and interbank trade financing, across markets and currencies. He focuses on dividend, bond, and income funds, with a strong focus on ETFs.Juan is a contributor to the investing group CEF/ETF Income Laboratory holdings are also monthly-payers, for faster compounding and steady income streams. Other features include 24/7 chat, and trade alerts.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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