Choosing The Right Emerging-Market ETF

It’s been a rotten year for emerging markets. The iShares MSCI Emerging Markets ETF (EEM)—the most popular way for investors to play the sector—is down 13% year to date. And several individual country funds have gotten hit a lot harder. The iShares MSCI Brazil ETF (EWZ) is down 23% year to date, and the iShares MSCI Turkey ETF (TUR) is down a whopping 26%.

Ouch.

Lethal Cocktail
A slowdown in China, a political crisis in Turkey and the Fed’s “taper scare” combined to mix a lethal cocktail for the sector. But now that the dust has settled, are emerging markets a buy?

Yes. With American stocks looking close to fully-valued, investors are shifting their attention to developed Europe, where valuations are nearly 40% lower. And as risk appetites return, I expect them to turn to emerging markets next, where pricing is even better. As measured by their price/book ratios, emerging markets as a group trade for less than half their pre-2007 valuations.

Not 'If', But 'How'
The question is not “whether” to buy emerging markets but “how.” As a general rule, I’ve avoided the iShares MSCI Emerging Market ETF because I consider it far too heavily weighted to developed markets such as South Korea and Taiwan and to companies that get a large chunk of their revenues from exporting to America and Europe. Its underlying index recently started to include Greece.

Yes, Greece. While I agree that Greece shouldn’t be classified as a developed market, I don’t see a lot of “emerging” going on there.

Other broad ETFs give better access to the emerging market consumer. One that I use in my asset allocation portfolios is the Emerging Global Shares Emerging Market Consumer ETF (ECON). The underlying companies get about 90% of their revenues from selling within their home markets and to other emerging markets.

The Long Term
I continue to recommend ECON as a long-term holding. But there are other ways to slice and dice the emerging markets universe, such as by dividend yield. James P. O’Shaughnessy, the author of What Works on Wall Street, wrote a paper earlier this year that found that a strategy of buying high-dividend emerging market stocks outperformed the broader emerging market universe by 10.6% per year. Yes, you read that correctly. 10.6% per year.

If you’re looking for an ETF solution, Emerging Global Shares offers one: the EG Shares EM Dividend High Income ETF (EMHD). The portfolio has an eclectic mix of emerging-market stocks you’re not likely to find anywhere else, such as Bangkok Expressway (BKENF), Telecom Egypt, and Ford Otomotiv Sanayi, Turkey’s local Ford subsidiary. In total, it holds the 50 highest-yielding stocks in the FTSE Emerging All Cap ex Taiwan universe, equally weighted, and is expected to sport a dividend yield around 8% (the shares only recently started trading, so there is no actual dividend history as of this writing).

Look For Liquidity
As attractive as EMHD is as a portfolio diversifier, it’s too thinly traded to buy at this time. Its average daily trading volume is a tiny 4,350 shares.

A more liquid option is the WisdomTree Emerging Markets Equity ETF (DEM).

DEM is based on a fundamentally weighted index that is comprised of the highest dividend yielding stocks selected from the WisdomTree Emerging Markets Dividend Index. At current prices, DEM yields 4.2% in dividends. DEM is a little too heavily allocated to basic materials for my liking, and its top two holdings—which collectively make up more than 10% of the portfolio—are Russian oil and gas companies. Still, if nothing else, DEM offers a way to get non-traditional exposure to emerging markets and access to companies you’re not going to get in the more popular emerging market funds.

Disclosures: Sizemore Capital is long ECON. This article first appeared on MarketWatch.

Charles Lewis Sizemore, CFA, is the editor of the Sizemore Investment Letter and the chief investment officer of investments firm Sizemore Capital Management.