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By Christian Charest and Patricia Oey | 10-07-2013

How do you take your emerging markets?

Cap-weighted indexes aren’t the ideal solution, but there are alternatives. ETF analyst Patty Oey sums up the panel discussions at the Morningstar ETF Invest conference.

Christian Charest: For Morningstar, I'm Christian Charest, coming to you from the Morningstar ETF Invest Conference in Chicago. I’m here with Patty Oey, who is an ETF analyst with Morningstar. She’s also our specialist on emerging markets.

Now, you just moderated a session on emerging markets and several different points were brought up that were very interesting. One of the points was the fact that inflows into emerging market funds were still positive; they’re still positive despite the recent returns that have been less than favourable. But you mentioned that those flows are going into active strategies rather than traditional cap-weighted ETFs.

Now, what are some of the issues with cap-weighted funds that make them less appealing for emerging markets?

Patty Oey: Right. Well, two very popular funds are iShares market cap-weighted fund, and there is also a Vanguard one. I think investors are starting to realize actually that these cap-weighted funds, they do have some drawbacks. Number one, in terms of country diversification, it’s not very good. China and Brazil are relatively much larger than some of the smaller countries. So, those account for a bit part of the index.

With Taiwan, Taiwan is actually not a very large economy, but it has a very large capital market. So that also tends to have a heavy weight in a cap-weighted index. So those three countries, they can account for about 40% to 50% of a cap-weighted index, and then the remaining 20 or so countries they have to share the rest of that 50%, 60%, so you’re not getting very good country diversification.

Another issue with cap-weighting is that, whereas the S&P 500, when you buy an S&P 500 fund, what you’re getting is U.S. blue chips and these are very big, very successful, very well-run companies. In emerging markets, a lot of the larger companies, they tend to be actually government-owned entities. When you have a government-owned entity, they’re not necessarily always focused on profitability. Sometimes they have to fulfill either political goals or economic goals, and so maybe those aren’t necessarily the best companies to invest in.

Finally, we also note that in a cap-weighted strategy, there is relatively lower weightings in companies that tend to benefit more from the general themes in emerging markets, which is rising middle class and growing domestic consumption. Cap-weighted indexes tend to have less of those types of companies that will benefit from those trends.

Charest: One of the alternatives that was talked about during the presentation was factor-based strategies or smart beta. What did the panellists s have to say about that?

Oey: Right. So smart beta could be – these are kind of factor strategies like value or low volatility or dividend. These are all – I mean, they are popular for developed markets and they’re also more – they’re getting more popular in emerging markets. Those risk premia or those strategies actually do work in emerging markets. So we do see a small cap premium in emerging markets. We do see a value premium. We also see a low-vol premium. So those strategies do work and we’re starting to see them in products and now investors can use those products.

What I would caution is that these products and the indexes, they kind of have a short track record. So it’s something that, I think, is interesting. I think it’s a good development. I think these products are likely to be pretty good, but it’s important for investors to kind of really understand how these products are constructed and sometimes they have annual rebalancing or semi-annual rebalancing. It’s important to monitor the portfolio and to see when the portfolio changes, is the portfolio still meeting your investment criteria. So it’s something to watch. I think it’s a good development, but still a relatively new product.

Charest: Another popular strategy has been to focus on dividends. Now, one of the panellists was a representative from WisdomTree, who sponsors the largest emerging market dividend-focused fund in the United States. What were some of his insights on that?

Oey: Right. So dividend investing in emerging markets, I mean, some of his arguments were: A, dividend investing kind of lets the portfolio tilt a little towards quality, whereas with earnings, there is some kind of – you can use accounting, slight of hands to kind of manage your earnings, whereas dividends are dividends. So if they’re paying a dividend, it is what it is and so if you weighed by their biggest fund, the WisdomTree Emerging Markets Income, they weight their holdings by dividends paid. It results in a slight quality tilt; tilts a little towards value, and historically the fund has done well, although it has a six-year track record and over that time period has done well.

Although, I do want to highlight that this fund, it does highlight one of the risks in emerging markets. So one of the things with this fund is that you are trying to get more high quality companies. Interestingly, what happened in China and Russia over the last two years is that those countries are trying to encourage their state-controlled or state-owned companies to pay out higher dividends. Part of this is to attract more foreign investors into their securities, and also because the government owns these companies, when they raise their dividends, the government is also getting more money. So there is kind of a win-win situation.

But that said, the WisdomTree fund ends up having more of these kinds of companies. So when you’re trying to kind of get more higher quality companies, actually you are seeing like Gazprom, which is a – it’s kind of a black box company run by the Russian government; it’s an oil company. Then you’re seeing these Chinese banks, a lot of investors are very concerned about Chinese banks and the health of their balance sheet. These companies are now – have a very significant weighting in the WisdomTree Emerging Markets Income Fund.

But that said, those – because you use dividends to weigh the holdings, there is little bit of a valuation – a value by us. So those names tend to be very – they are trading very cheaply, so it does provide little bit of a floor in terms of how low you can go, because it’s already trading very cheaply. So there are some safeguards there.

Charest: Now, one strategy that’s been extremely popular both in Canada and in the U.S. has been low volatility, and that applies to pretty much every segment of the market, including emerging markets and there were some good points that were brought up again today in the presentation.

Oey: Right, right. So low volatility also works in emerging markets. It also has had a good recent track record. One of the important things is that it reduces volatility, so like in 2008 whereas the cap-weight, it went down more than 50%, low volatility went down less. So to recover from a deep decline, if you have a lower dip, it’s easier to recover. So that’s part of the reason why it’s done relatively well. Yet, it is a good strategy again. It’s relatively new, so it’s definitely something we should be monitoring, but it does work. One of the panellists, he has done some research into low volatility. In the U.S., low volatility, it does load a little on the value premium or – on value stocks and in emerging markets actually there is less of a value tilt. Actually there is a stronger low volatility alpha, so low volatility; it does work in emerging markets.

Charest: Interesting. Thank you very much, Patty.

Oey: Thank you.

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