Twenty20 Investments - iBasket

4. September 2013 16:58
by Allan

Is it time to selectively reconsider Emerging Markets ETFs?

4. September 2013 16:58 by Allan | 0 Comments

As we head to the 5th year anniversary of the default of Lehman Brothers the reverberations of the biggest global financial crisis in modern times still can be felt, and no more so than in the Emerging Markets segment.  For those not paying attention in the back row of the classroom what we learnt was that the globalization of hot money flows was the 'force' to reckon with.  As the months and years rolled by post 2008, with many of the economies, both developed and emerging, suffering under a mountain of debt, it seemed the only ticket in town was the bull market commodity run.  With some economists suggesting that this super-cycle of commodities is now behind us it was only natural that a number of key Emerging Market countries would in turn suffer.   

Roll forward to mid August 2013 and what one might describe as a 'turn on a six pence' all of a sudden the world seems a differen
t place.  Continuing bullish headlines for the UK's economy and housing market, France & Germany's very encouraging GDP figures pulling Europe out of recession.  This news alone has reversed the sentiment for investing in Emerging Market equities, both the US and Europe are now open for business again, and just as the many Emerging Markets show continued signs of economic fatigue, the proverbial West is coming to the rescue.  

Any student of Ruchir Sharma's book, 'Breakout Nations' knows not to treat this extensive set of distinct countries and regions as an homogeneous ensemble.  Indeed. looking at the correlation matrix across a range of 29 Emerging Market ETFs listed in Europe, including single country equity exposure, local currency bonds, USD bonds, select dividend, etc, shows a wide range of pairwise correlations.  This observation is not restricted to the equity-bond correlation pairs but can be seen between separate equity ETFs, for example the monthly returns from iShares MSCI Korea (IKOR) and iShares MSCI Turkey (ITKY) display a very low correlation.  There is great variation across Emerging Market equity returns, however with the volatility of equity index returns generally being on the high end of the spectrum, the issue of market timing is even more important.  Nonetheless, the last few months has seen a number of ETFs recover from their low points, SPDR® S&P Emerging Markets Dividend ETF (SPYV) down 9% in June, up 4% since then, SPDR® MSCI Emerging Markets Small Cap ETF (SPYX) down 7% in June, up 2% since then, Vanguard FTSE Emerging Markets (VFEM) down 7% in June up 4% since then and finally iShares FTSE China 25 (FXC) down 8% in June, up 11% since then.

Generally the topic of idiosyncratic risk shows its hand when investing in single stocks, it must be said though when using ETFs to access Emerging Markets expect the unexpected.  Recent riots in Turkey, Egypt and Brazil has not made the investment landscape any easier.   Policy changes in India that have come on the back of the Rupee's plunge reminds one of the time a couple of years or so ago when Brazil enacted currency controls to dampen the flow of hot money into the booming equity markets.   This all suggests one should choose one's single country exposure wisely.  At the time of writing the MSCI Emerging Markets index is down by about 8% year to date, in direct contrast the the MSCI World Index which
 is up about 14%, suggesting that the Emerging Market segment now looks like a buying opportunity.  Of course an alternative is to instead buy a basket of one's favorite single country exposures, risk weighted to partially achieve a maximum diversification score, while filtering out those countries that currently require a 'barge pole' approach to investing, such as Brazil and Egypt.

With the benefit of hindsight one can say for sure that some benchmark indices will have fared much better than others, but with so many products to choose from it is far from obvious what selection criteria to apply when selecting a non-cap weighted index over a traditional construction.  While there seems no end to the number of new ETFs coming to the market, in many instances the length of the historical data sets will be somewhat limited and concrete statistical evidence to favor one choice over the other will be thin on the ground.  To this author at least, the main decision to make is to get the country or regional exposure well thought out,  and one should consider the benefits of bespoke indexing as the icing on the cake.  When in doubt one can always diversify across a small handful of available ETFs.

Thank you for visiting the ETF Managed Portfolios Blog Top