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iShares MSCI Emerging Markets ETF (NYSEARCA:NYSEARCA:EEM) is an exchange-traded fund that enables investors to get exposure to mid- and large-cap emerging market stocks. The breadth of EEM is high, with 1,242 holdings reported as of December 31, 2021. The top 10 holdings represent about 24.34%, which is of course much larger than 1 / 1,242 (0.08% if the fund were equal weighted). However, 24% is not a high level of concentration if compared to most other ETFs with focused allocation strategies.
(iShares)
The expense ratio of EEM is quite high at 0.68%; this is the kind of ETF that you would probably want to feel a high level of conviction in (i.e., you would want to be shooting for material outperformance) in order to justify the cost. Assets under management for EEM were reported as being $29 billion as of December 31, 2021, indicating a relatively high level of popularity. But it is also worth noting the direction of flows in/out of EEM specifically. Recent flow data is illustrated in the chart below (one-year trailing basis).
Flows seem somewhat "quiet" but are nonetheless positive; we do not see outflows at least. Net inflows were up by over $2.4 billion over the past year, as reported. But it would appear that investors are more or less coasting on EEM at present.
How is EEM performing? The fund has not performed too badly recently, although the most recent highs were set in the first quarter of 2021, and as shown below, EEM shares are back under their prices set all the way back in 2007 (only in Q1 2021 were those 2007 highs taken out, briefly).
(TradingView)
Since we know that U.S. equities have performed rather well over time, and especially since the 2009 lows, there is no need to compare EEM to any of the popular U.S. equity ETFs. We know that EEM is quite clearly underperforming; treading water, essentially, over a long period of time.
I last covered EEM in October 2021. I was bullish on the basis of the fund's high implied cost of equity, of probably 10% or so, but since then the fund has fallen by around 3-4%, while the S&P 500 (a popular U.S. equity index) has appreciated by about 9%. The negative alpha is unfortunate but evidently not a departure from EEM's history.
Ultimately, capital is finite, even if much capital is sloshing around markets. Despite recent positive inflows, EEM is of course not the only vehicle through which its underlying holdings receive bids. On the whole, it would appear that there is just not enough demand in emerging market stocks at present. Yet EEM has outperformed before, from inception in 2003 through to between 2008 and 2010 (see the ratio between EEM and SPDR S&P 500 ETF Trust (SPY) below, the latter being a popular S&P 500 index tracker).
Could we see another rotation as we saw into the 2007/08 crisis? There was a fairly substantial regime change in markets after that time; tech stocks began a multi-year ascendancy. As our global economy, especially in the western world, has become far more technologically sophisticated (and supported by internet and software-based platforms), tech companies have earned high returns on equity that have dwarfed those of traditional businesses.
EEM remains invested fairly heavily in more traditional businesses, with Financials, Communication, Staples, Health Care, Utilities and Real Estate together representing 44.44% of the fund as of December 30, 2021. You do have a high tech exposure too, at 22.75%, but this is evidently not enough to save the fund from underperformance.
(iShares)
EEM is also allocated heavily toward China and Taiwan. I have provided some discussion in other articles regarding Chinese and Taiwanese equities (equity ETFs specifically). These markets are quite risky from both geopolitical and financial (regulatory) perspectives. I have been saying that Chinese equities have been under-pricing the risk, and in more than one article successfully predicted that Chinese equities have been overvalued due to this mispricing.
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So, EEM is likely both risky (in terms of its geographic exposures) and "under-weight" higher-ROE sectors. So, it is naturally going to be a struggle for EEM to outperformance broader U.S. equity indices. If the United States starts to hike rates more than expected to counter inflationary pressures, this could strengthen the dollar and thus hurt EEM further (as its underlying holdings are priced in non-USD terms). However, tighter U.S. rates may also hurt the leading U.S. stocks disproportionately, as higher discount rates could compress valuations that are often based on long-term earnings growth trajectories.
Higher U.S. rates could therefore make EEM attractive, as it could represent a value-oriented investment proposition. But value does often struggle to outperform growth, I would say mainly because value stocks (often in more mature sectors) do not attract as much (finite) capital; equity risk premiums are usually higher, due to a lack of exciting long-term earnings growth rates. Lower underlying returns on equity also provide less of a long-term compounding opportunity for investors; valuations remain tighter as a result.
EEM tries to target its benchmark, the MSCI Emerging Markets Index. The most recent factsheet for this index indicates a forward price/earnings ratio of 12.19x, and a trailing price/earnings ratio of 13.93x (for November 30, 2021). The price/book ratio is low but unexpectedly so, at 1.84x. Dividing price/book into the forward price/earnings ratio, we arrive at an underlying return on equity of 15.1%, which is actually quite good, but not as strong as the U.S. equity indices which are more heavily invested in tech. An ROE of 15% is moderate; higher than lower-ROE geographies like Japan, but under the most productive countries like the United States (you can often see ROE rates of over 20% in plenty of the best and diversified U.S. equity ETFs).
Also, while the forward earnings yield of EEM, as implied by its MSCI index, is about 8.2%, this should also be weighed against the fact that emerging markets often have higher rates of inflation and interest rates, as well as higher equity risk premiums (due to country-specific risks; I already mentioned China and Taiwan, for instance). Using data provided by Professor Damodaran, I calculate the appropriate cost of equity as being 9.00% for EEM.
(Author workings)
I used 10-year government bond yields as the risk-free rate component of the cost of equity equation, sourced from World Government Bonds. Due to the lack of bond data for Saudi Arabia and United Arab Emirates, I used the most recent year-over-year CPI inflation rates as loose proxies. In any case, 9% is a fairly high cost of equity. I feed this into the short-term valuation gauge below, which also includes a consensus average earnings growth rate over the next few years in the region of 15% (in line with Morningstar's reported consensus estimate).
(Author)
The implied valuation suggests more than 60% upside, but after implied forward-year earnings growth of about 14%, I had to just assume 15% per year to find my consensus earnings growth figure of about 15%. This seemed quite sanguine and optimistic, and so, it would seem that the market is either not believing in the analyst consensus that I have seen, and/or investors are pricing in greater equity risk premiums than would typically be deemed as fair.
If I keep the assumptions the same, the implied cost of equity is about 13.7%, which is your implied return if earnings are as strong as predicted by Morningstar analysts. However, if instead we see an earnings growth trajectory that, say, falls off gradually from 14% down to about 5% by year five and the terminal year ("year six"), the implied cost of equity would be 10.8%.
In another situation, if we just assume 5% earnings growth after the first year, the implied cost of equity (i.e., your return) is projected as being about 9.9%. Therefore, after considering a range of medium-term scenarios that are not unrealistic, the implied return is between about 10 and 14%, which is actually quite high all considered. I think this might also help to explain why EEM investors are holding on, and why we are not seeing significant outflows.
While EEM is not especially "exciting", the decent underlying ROE of around 15% and the implied return profile of over 10% lead me to continue to hold a bullish view on the fund. Due to the lack of historical outperformance, I think one must be patient in this case, and probably not make any significant allocations. But some exposure to EEM could make sense and also provides one with an implicit short-USD hedge.
