john@johnducas.com

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VWO: The Return of Emerging Markets

Emerging markets, probably one of the most despised sectors in 2013. It has been down roughly 5% since the start of the year; the main factors that caused the slowdown were higher inflation, drops in currency values and mainly a downturn in foreign investment, which was due to the financial crisis.  In this article, I will be going through the current Emerging Market situation and giving you insight on the ETFs that are positioned in it.

 

 

Emerging Markets

 

 

We have recently seen a short market turmoil, which lasted from May to August 2013. The turmoil was due to fears of a U.S. debt default. Over that period, emerging markets lost more than 12%, while 3% was lost in developed markets. This points to the possibility that EMs have more room to rise back. Tim Ridell, the head of global markets research at ANZ said, “While the current scenario is supportive for risk appetite, investors are unlikely to be gung ho due to this uncertainty”. Though he did also say that he expects both Asian and US markets to continue their ascent for the rest of the year.

 

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Over the same period of time, the IMF published a report, which gave a negative outlook on emerging markets. In the report, they argue that the region is suffering from a cyclical downturn and weak growth prospects. This is not true as the under-performance was exclusively cyclical. The gap between the emerging market and developed market performance is due to monetary policy (Quantitative Easing) employed by developed markets (United States, United Kingdom and Japan). In Q4 2013, some emerging markets should outperform because of the use of their Central Banks’ policies, which allows the domestic demand to counteract slowing export growth.

 

Kelly Teoh, a market strategist at IG agreed with some of the worries posed by the report but also said that “IMF reports tend not to be forward looking and can often be behind the curve”, adding that the IMF could be underestimating the region’s growth prospects.

 

A fact many people oversee is that for the first time in history, emerging markets account for more than half of the world’s GDP in terms of purchasing power according to the IMF. Just 20 years ago, in 1990, emerging markets only accounted for under one third of GDP. Here is a chart from The

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Economist, which shows the emerging-market share of world GDP in PPP. If you take a look at 2003 to 2011, you can see that the output emerging markets provided grew at more than one percentage point per year.

 

A recent study showed that from 1960 to the late 1990s, only 30% of developing countries managed to increase their per capita GDP quicker than America did, this phenomenon was named “catch-up growth”. This increased from the late 1990s and researchers found that by then, 73% of developing countries had overtaken American growth. Among those countries were four that grew at extremely high rates: Brazil, Russia, India and China. They were so impressive and unique that they were given the acronym BRIC. Those BRIC countries changed the global economy in many different ways. Labor and cost of manufacturing dropped, while commodity prices went through the roof; unfortunately though, the economic imbalances made way for a time of financial insecurity and consequently a global crisis. The fact that labor was more accessible created larger wealth gap as well as wage stagnation. So as you can tell, those large emerging markets affected the globe in both positive but as well negative ways.

 

The movement towards emerging countries will continue; it seems as the turbulence has ended, or is at least close to ending. In the emerging markets, we are seeing a minor pulling back of BRIC countries as their growth decelerates and an addition of new EMs, the N11. The N11 or “Next 11” are countries that are showing high growth potential. They include: Bangladesh, Turkey, Nigeria, Indonesia and Mexico. The average per person output in those counties is 14%, which is higher than when BRIC economies started displaying high growth figures. Although it is unlikely that they overtake BRIC, it does nevertheless also mean that there will be more emerging markets to accommodate the rest of the worlds growing needs.

 

Commodity prices, economic growth and inflation have all been declining. The global CPI has fallen from 4% in 2011 to 2% now. This is a great plus for emerging markets, as they are now free from the debt that has taken over the developed countries. This will consequently allow central banks in emerging markets to further ease monetary policy.

 

All the fiscal and monetary policy being implemented in both developed and emerging countries will end in an increase in global growth, which will be accelerated in developing markets. Growth will also be correlated with a rise in commodities and therefore result in even higher levels of growth in emerging markets.

 

 

 

 

 

ETF Comparisons

 

 

The big three Emerging Market ETFs are currently the iShares MSCI Emerging Markets Indx (EMM), the iShares Core MSCI Emerging Markets ETF (IEMG) and the Vanguard FTSE Emerging Markets (VWO). They all have many things in common, such as the fact that their largest single country exposure is in China. They all have holdings in countries such as Brazil, Taiwan, South Africa, Russia, Mexico and Malaysia but also companies like Taiwan Semiconductor Manufacturing (TSM), China Construction Bank (CICHY.PK) and China Mobil (CHL) constitute their top four investments. Although they have many things in common, they do have slight differences, which appeal to different investors.

 

 

Here they are:

 

 1. In 2012, it was announced that VWO would switch from its MSCI fund tracking indexes, to FTSE. The switch in the tracking index itself doesn’t really mean much to the average investor, but what does is the fact that the FTSE index does not consider South Korea to be a developing market. This means that all of VWOs holdings in South Korea, which made up roughly 15% of the fund, had to be cut. Even if you are a believer in South Korea, there is a big factor to consider. MSCI could actually also classify the country as being developed, which would mean that IEMG and EMM would have to cut their exposure to South Korea. In fact, it is currently under review for reclassification in MSCI’s “2014 Annual Market Reclassification Review”. The announcement of whether the country is reclassified will be in June 2014.

 

2. As of the 29th October 2013, IEMG’s 30-day SEC yield is 2.29% and VWO’s is right under 4% while EEMs is just 1.88 %. A higher dividend yield will provide for more downside protection.

 

3. As of the 28th October 2013, IEMG holds the greatest number of stocks with 1753. EEM holds the least with 821 while VWO is right above with 926 stocks. Therefore, IEMG is clearly the most diversified. Something to be noted is that even if IEMG owns the most stocks of companies, its top 10 holdings still make up nearly 14% of the fund, which of course is smaller than the 16% for VWO and EEM, but even though it has considerably more stocks in its portfolio, it doesn’t mean that it has much less exposure to its top holdings.

 

4. Commissions are also something to be looked at. VWO at Vanguard and IEMG at Fidelity carry no commissions. EEM, on the other hand requires you to pay a certain commission.

 

 

 

I created a spreadsheet where forecasts were calculated for different International equity ETFs compared to VWO and EEM. Below are what the terms mean:

 

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(click on the image to enlarge)

I created a spreadsheet where forecasts were calculated for different International equity ETFs compared to VWO and EEM. Below are what the terms mean:

 

  • The Range Index measures what proportion of the forecast range lies in opposite directions
  • The Odds/ 100 column gives the percentage of the experiences that ended in gains above cost and the Payoff column gives the average gains
  • The Days Held column tells the average number of market days a position requires to be held
  • The Annual Rate of Return is a measurement of productivity of the capital invested to previous forecasts (past 5 years)

 

 

Both VWO and EEM have a 7.2% short-term price target. The main difference is the downside. VWO only has 5.3% downside risk while EEM has a 8.50% risk.

 

 

VWO

 

 

I personally chose to go with the Vanguard FTSE Emerging Markets ETF. VWO invests and allocates capital in publicly traded stock of companies which are located in countries considered to be emerging markets, such as China, South Africa, Brazil and Taiwan. Vanguard claims that the ETF ‘has a high potential for growth, but also high risk; share value may swing upand down

vwo risk

more than that of stock funds that invest in developed countries, including the United States’. The diagram Vanguard provides illustrates this happening.

 

VWO provides a 4% dividend yield at its distressed current value. Downside for the ETF is rather limited from the current standpoint. Using a simple example;

 

 

Imagine Security X offers a $1 dividend and stands at $10 a share:

 

$1 / $10 = 10% yield

 

(If the price were to drop 10%)

 

$1 / 9 = 11.1% yield

 

Every 10% drop in price of the security will add 11% to VWO’s effective Yield. The fact that the dividend yield is higher than other ETFs in the same sector means that in the event of a decline, the dividend should provide a fair amount of protection.

 

The Vanguard fund has an Expense Ratio of just 0.18%, which is 89% lower than the average expense ratio of funds with similar holdings.

 

 

Risks

 

 

Betting on Emerging Markets is a truly risky investment, but with great risk comes great reward.. . or loss. Emerging markets provide many risks that cannot be ignored, such as:

  • Adjustments in currency have led to narrow deficits. Since 2005, the value of the Yuan has increased by about 35% versus the US dollar.
  • Reserve outflows have also been an issue for a few emerging markets.
  • India is as well going through some rough patches, from 2004 to 2009, it hasn’t been able to create new employment.

The worst-case scenario would be in the case of another economic crisis. A weaker global economy could place significant amounts of pressure on emerging countries’ financial systems. Another case would be if Central Banks don’t manage to austere capital outflows, the slow growth could lead to pure contraction.

On the other hand, slowdown could not necessarily be a bad thing; on the contrary, it could be a huge profit maker. For instance, a deal that focused on non-tariff trade barriers would be great news for Emerging Countries.

 

 

Conclusion

 

 

Like mentioned multiple times, Emerging Markets provide a lot of risk. This is how I like to look at the current emerging market situation; investing towards the end of a bull market cycle takes much more precision than investing during the start of a new one. Adversely it is more important to have exposure in the beginnings of a bull market than it is to be precise. For that reason emerging markets seem like such an appealing investment to me, the start of a bull market coupled with the higher risk-higher return prospect provides for a nice growth recipe.

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