Broad Emerging Market ETFs – More Risk – Less Return

Emerging Markets Di-worsification

In the search for portfolio diversification many investors like to shift their exposure outside of their domestic market. Financial planners have always talked about how owning too much of your own employer’s stock is a dangerous gamble – the same turmoil that might send shares down may kick the holder out the door. So many investors have taken it upon themselves to diversify their portfolios outside the ramifications of domestic equity. Products such as the iShares MSCI Emerging Markets ETF (EEM) or the Invesco Emerging Markets Sovereign Debt ETF (PCY) can offer investors the exposure they desire to foreign markets in equity and debt.

EEM and PCY
EEM and PCY

However, emerging market ETF’s have seen a poor year so far, failing to live up to investor expectations and effectively diworsifying their portfolios. The poor performance warranted investors discussing the actual efficacy in using EM ETF’s in times of political and economic instability in the underlying assets’ nations.

Emerging market ETF’s expose themselves to nations that are still subject to greater political risk that closely impacts the fund’s holdings. In emerging markets, it is often impossible for a company to warrant investor attention through its growth without having undertaken some political risk in achieving said growth.

The Staple EM Basket

A discussion of emerging markets is seldom complete without the mention of Turkey, Brazil, South Korea, and China.

Normalised YTD return for country ETFs of China, Brazil, South Korea, and Turkey.

Turkey, a country that has been a staple of many emerging market portfolios, has dealt with close to 21% devaluation of the Lira against the US Dollar since the start of the year that has put a strain on equity and debt markets. Economic instability has clearly reflected in iShare’s MSCI Turkey ETF.

Brazilian company shares also remain under pressure as the weakening Brazilian Real puts a dent in iShares MSCI Brazil Capped ETF (EWZ). On Wednesday EWZ fell as much as 3.6% on the announcement of the Brazilian Central Bank cutting its 2018 GDP forecast from 2.6% to 1.6%.

While previously escalating tensions between North Korea and South Korea has played a role in the the MSCI Korea Index (EWY), and despite political de-escalation Q2 has still left investors with a bitter taste in their mouths. Poor performance on behalf of the biggest holding, Samsung Electronics Co., has dragged down the ETF.

Finally, Chinese companies have had to deal with a myriad of obstacles since that start of 2018 that have spanned across most industries. Hong Kong and China make up 31.59% of the EEM ETF exposure. Investors are pricing in the effect of trade wars into Chinese equity, and all factors point to things getting worse before they better.

With most emerging market ETFs effected by factors of economic or political adversity a passive investment strategy does not yield the most opportune results. In the case of EEM, the fund is down 16% off its ATH in late January, and has retraced to August 2017 price levels – largely representing a huge opportunity cost to many investors.

Seeking Exposure

Passive investment strategies do not cut it anymore, and individual investors should take note to rebalance their portfolios away from emerging market ETFs – unless their exposure is actively managed. While actively managing emerging markets exposure may go against many buy-and-hold ideologies prescribed by numerous bestselling investor books, emerging markets – at wide exposures does not provide the investor and diversification benefits. Actively managed portfolios are able to circumvent times of economic uncertainty.

Many investors argue that the addition of a passive emerging markets investment strategy would provide less diversification than anticipated because growth portfolios are already exposed to emerging market uncertainty even through domestic stocks.

High-cap growth stocks such as Alphabet (GOOGL), Amazon (AMZN), VISA (V), or Home Depot (HD), all have established relationships with international markets, whether they are filling an existing demand or are the recipients of a good or service. Ultimately, company revenues will be effected by emerging markets either way. Further investment in broad emerging markets would only append more risk to the exposure found in high-cap growth style ETFs such as the iShares Russell 1000 Growth ETF.

Should an investor still seek emerging markets diversification, this can be done by outright ownership of foreign company shares listed domestically – such as Alibaba (BABA) or Yandex (YNDX), or through a country-specific ETF. Despite traditional EM players down YTD, other countries such as Russia, Columbia, and Israel remain positive.

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