Trend Talk: Go With The Flow In Emerging Market ETFs - For Now

Includes: EEM, VWO
by: Mark Scheffler

Investing in emerging market ETFs has become increasingly popular for both individual investors and professionals alike, highlighted by the Vanguard MSCI Emerging Market ETF (NYSEARCA:VWO), and iShares Emerging Market ETF (NYSEARCA:EEM). Both have demonstrated extended periods of rising price trends (as has been the case since mid July, 2012), and of course both experienced massive losses during the global economic meltdown of late 2007-early 2009 and again in 2011. The most fundamental piece of data that causes both rising and falling price trends involves capital flow - Is capital flowing into or out of emerging markets, and what effect does that have on the price trends of emerging market ETFs?

When capital flows into or out of any investment - especially emerging markets - it creates opportunities for the investor to measure these flows, to identify trends, and to make meaningful and impactful asset allocation decisions to keep a portfolio "on the right side of the market." Other Seeking Alpha contributors have written extensively (and correctly, I might add) about the importance of capital flows, including David Hunkar, Research Recap, and others. For emerging market ETF investors to be most successful, they need to be aware of and able to respond to changes in capital flows in real time. And this market segment is an excellent candidate for an innovative research technique called "trend analysis."

Trend analysis uses advanced cloud-based computing technology to measure current capital flows as reflected in price trends for any ETF, open- or closed-end mutual fund, individual stock, and any market index that has been unitized. While the aspect of having this technology in the cloud isn't the main driver, the robust calculation methodology and the ability for investors to access the outcomes of this research method are. Using trend analysis, investors can determine how sensitive they should be in making tactical portfolio adjustments when capital flows turn, reflected in price trends. Why price? Our research indicates that no other data point is more meaningful in offering a real-time daily capital flow analysis. Using the Vanguard MSCI Emerging Market ETF as an example, trend analysis can identify key turning points in the price of this ETF and prescribe portfolio adjustments to keep investors on the right side of the market.

For investors familiar with simple moving average crossover techniques, this type of analysis will be familiar. Simple moving average (SMA) crossover often involves pairing at least two trend lines - often a short-term trend with a longer-term trend - that is built simply by averaging daily closing prices for a given number of days Researchers often point to the crossing of the 50-day and 200-day simple moving averages as a key inflection point (you may have heard of the terms "golden cross" when the short term trend crosses above the long-term trend or "death cross" when the opposite occurs. But a more robust and accurate analysis indicates that for VWO the primary trend combination currently stands at 45 days and 69 days - a far more sensitive combination.

Why these two time periods? Trend analysis presents a far more detailed calculation than has been possible in the past. Our analysis for VWO has currently identified more than 517 million SMA combinations that have produced growth - they're all over the place! But using this primary combination - along with three additional simple moving averages - yielded significant benefits:

  • Cumulative return since the inception of the security of 487.15% compared with a return of 75.02% for a buy & hold investor (data through 10/30/2012).
  • Inherent risk management, in this case reducing the maximum investment drawdown from 67.69% for a buy & hold investor to a much more reasonable 25.99%.
  • A 92.31% success rate in generating capital gains.

All metrics assume no shorting is used at any time, and are presented gross of trading fees. In general, shorting consistently increases both the cumulative returns over time and the standard deviation.

For a more complete analysis, click here to view an on-demand VWO Trend Talk feature. Additional metrics are available to model the effect of shorting and the use of half positions on both cumulative growth and drawdown.

Disclosure: I am long VWO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.