Should You Overweight Emerging Markets?

Includes: EEM, EEMV, EFA, SPY, VWO
by: The Financial Lexicon

Fellow Seeking Alpha contributor and Global Chief Investment Strategist for BlackRock's iShares ETF business Russ Koesterich recently wrote the article, "As Global Growth Falters, Consider Emerging Markets." In it, he cites the IMF's lowering its global growth forecast and anemic growth across the United States, Europe, and Japan as reasons investors "should consider being overweight emerging market stocks." Additionally, he states, "In particular, we continue to like China, Brazil, Indonesia, and Russia," before going on to recommend the iShares MSCI Emerging Markets Minimum Volatility Index Fund (BATS:EEMV). There are three points of contention I have with Koesterich's article:

The first point of contention has to do with the ETF he proposed retail investors consider, EEMV, relative to his aforementioned statement, "In particular, we continue to like China, Brazil, Indonesia, and Russia." As of October 16, 2012, exposure to China, Brazil, Indonesia, and Russia made up less than 30% of EEMV. The table that follows shows the fund's exposure by country for the ten countries with the highest weightings in EEMV:







South Korea




South Africa












As you will notice, China, Brazil, and Indonesia make up 25.08% of the fund. Russia isn't even in the top 10. For argument's sake, let's assume Russia is 11th with a weighting of 3.87%, which would put it just under Colombia's 10th place weighting. If that were true, the total weighting for China, Brazil, Indonesia, and Russia would be 28.95%. Even if you agree with Koesterich's assessment that those countries are the ones to like, it is important to realize that EEMV will not get you the exposure you might assume it would given the countries that were highlighted in the article. In other words, the article specifically mentions four countries that investors should target among emerging market countries but then recommends a fund that has an inadequate collective weighting to those four countries.

Two other popular emerging markets ETFs investors might consider are the iShares MSCI Emerging Markets Index Fund (NYSEARCA:EEM) and the Vanguard MSCI Emerging Markets ETF (NYSEARCA:VWO). These ETFs have exposure to China, Brazil, Indonesia, and Russia of 38.87% and 38.90% respectively. This is certainly better than EEMV's, but it leads me to my second point of contention with the article:

Even though certain emerging market countries may see growth pick up next year does not in itself make emerging markets an area to overweight. Emerging market funds have had strong directional correlations with U.S. equity market indices for years. If you want to argue that emerging market funds are the manner in which investors should express an overweight to certain emerging market countries, you will have to either believe that U.S. equity indices will rise next year or that correlations that have held strong for many years will suddenly break.

The article, however, paints a bleak picture of growth in the U.S. and even mentions the possibility of a recession next year. That type of discussion will leave many investors feeling rather shy about expressing confidence in U.S. equity indices for 2013. On the other hand, the article says nothing about historical correlations between emerging markets and, for example, the S&P 500 (NYSEARCA:SPY). The following chart illustrates the directional correlations between SPY, EEM, and VWO. EEMV has only been in existence for approximately one year and was therefore left off the chart.

EEM Chart

EEM data by YCharts

While certain country-specific equity markets may decouple from the major market indices in the U.S., broad emerging market ETFs have struggled to do so. If you agree with Koesterich that emerging markets are worth an overweight in a portfolio, and you express that belief through broad emerging market funds, you will also need to believe the U.S. markets are worth buying or that correlations will break. Should you believe the U.S. markets are also worth buying (despite the bleak picture Koesterich painted of U.S. growth and the risk of a recession), then there would be no need to follow the recommendation to purchase EEMV when searching for lower volatility. Instead, you could simply purchase a fund tracking the S&P 500. After all, if EEM's beta of 1.59 (according to iShares) is one standard by which to measure the volatility of emerging market funds, then the S&P 500's beta of 1 will get you less volatility. The S&P 500 will also get you exposure to emerging markets through the overseas earnings of global companies underlying the index.

My third and final point of contention with Koesterich's article has to do with using the following statement to support his overweight emerging markets thesis: "Emerging market countries are still trading at around a 20% discount to developed markets." The fund he recommended in the article has a P/E of 20.50, and the popular emerging markets ETF, EEM, has a P/E of 17.34. The S&P 500, however, checks in with trailing 12-month and forward 12-month P/Es of 15.44 and 13.10 respectively. The iShares MSCI EAFE Index Fund (NYSEARCA:EFA), which has significant exposure to so-called developed markets, has a P/E ratio of 16.74. Using the S&P 500 and EFA as guides would indicate that emerging markets are actually not trading at a 20% discount to developed markets.

Perhaps Koesterich was referring to a 20% discount to historical valuations. If that is the case, then the following quote from his article is of relevance: "nobody expects China or India to return to their glory days of 10% or more annual growth." If "nobody" expects the two emerging market giants, China and India, to return to the historical growth rates that attracted so many investors to emerging markets in the first place, then why should investors use historical valuations as any guide for determining whether emerging markets should be overweighted in a portfolio?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any 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.