Is now the time to invest in broad Emerging Market ETFs?

Jun 9th, 2016 | By | Category: Equities

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Emerging markets have had a dreadful two years, but Tuesday heralded a 1.5% jump from MSCI’s Emerging Market (EM) index – its biggest gain since mid-April – following positive comments from Janet Yellen on the US economy and suggestions that an interest rate rise is coming.

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Emerging market ETFs have performed well this year

The index’s movement is a reversal of fortunes for emerging markets, which has seen it drop nearly 20% to 349 in the last two years. Over the same time horizon, the iShares MSCI Emerging Markets ETF (NYSE: EEM), would have dropped in value by 23%.

However, despite the asset class performing very poorly in general over the last two years with large asset outflows, there has recently been a turnaround.

Year-to-date MSCI’s EM index has seen net returns of 2.32%, this compares to total 2015 returns of -17.63%, according to data from MSCI. The index is made up of large- and mid-cap stocks across 23 emerging markets countries. It includes 837 constituents covering approximately 85% of the free float-adjusted market capitalization in each country.

Chanchal Samadder, Head of UK & Ireland Institutional ETF Sales at Lyxor, said: “We have seen strong inflows over the last two months. This has largely been driven by the Fed’s stance on rates, commodity prices stabilising and emerging market equities seen as being cheap on valuations compared to developed markets…

“With of the advent of ETFs it is possible to access almost every country defined as “emerging”,” he says.

In fact, ETFs tracking broad emerging markets have performed relatively well so far this year.

The Lyxor MSCI Emerging Markets UCITS ETF C-USD (LSE:LEML) costs 0.55% and tracks the MSCI EM index. It has returned 9.01% year-to-date, according to Bloomberg.

Bloomberg: LEML

Bloomberg: LEML

The Vanguard FTSE Emerging Markets UCITS ETF (LSE: VFEM), which tracks the FTSE Emerging Index has an ongoing charge of 0.25% each year, but year-to-date has returned 10.72%.

The SPDR MSCI Emerging Markets UCITS ETF (LSE: EMRG) costs 0.42% and also tracks the MSCI EM Index, it returned 10.41% YTD to May 31st.

PROBLEMS WITH EM

Despite this uptick there are still some fundamental problems with the asset class itself.

For example, the term emerging markets, coined in the 1980s, is becoming less relevant with the countries included often sharing very few common factors (aside from perhaps being difficult to access).

Samadder said: “The world has moved on and the fundamentals driving each country are very different.”

For example, China and Peru are categorised as emerging markets.  In the IMF’s World Economic Outlook 2015, China’s economy ranked second (after the US and European Union were tied in first place), while Peru was ranked 48th.

While the indexes reflect this with their weightings – of the ten top constituents in MSCI’s EM index five are from China – this may not be immediately obvious.

This sentiment is also reflected in how investors view emerging markets as an asset class, which has historically had a low weighting in portfolios. Samadder explains that if investors re-weight to neutral then it could stimulate significant inflows.  “Over the longer term we think countries like India and China will become core holdings in investor portfolios, rather than on the fringe, as these economies  become increasingly important drivers of global growth.”

He adds: “Despite the negative sentiment towards broad emerging markets over the last two years, there have been some exceptions, most notably India (due to the elections) and China where we saw strong inflows.

“However, there been a reversion this year with commodity dependent countries, such as Brazil and Russia, now seeing stronger performance and larger inflows.”

Data: Bloomberg

Data: Bloomberg

BRAZIL

The Latin America region, which uses Brazil and Mexico to drive flows, has been a significant underperformer relative to broader emerging markets, putting it out of favour with investors.

For example, the MSCI Latin America has fallen 33% compared to a fall of only 16.5% in the MSCI EM Index over the last two years. Much of this underperformance has been down to the major index weight Brazil, falling 40% over the same period.

Jade Fu, Investment Manager at Heartwood Investment Management, said:  “Latin American economies are hugely dependent on commodity exports. Price falls seen across the commodity complex over the last couple of years have undermined growth and contributed to a significant deterioration in public finances across the region. Worsening terms of trade for many countries has led to higher inflation and weaker currencies. In countries like Brazil, where governments have also overspent, the central bank has had to respond by increasing interest rates, rather than easing policy to support growth. Resultantly, business and consumer confidence have been severely knocked.”

The MSCI Brazil Index is designed to measure the performance of the large- and mid-cap segments of the Brazilian market. With 61 constituents, the index covers about 85% of the Brazilian equity universe. Performance from the MSCI Brazil Index has been haphazard at best. From having an annualised performance of 128% in 2009, last year it saw one of its lowest performing years returning  -41.37%. However, this year-to-date has been better with the net return being 22.45%, according to data from MSCI, which could make the country an attractive emerging market offering.

Fu said: “There are a few tentative signs that economic data is stabilising. Brazil’s first quarter GDP growth contracted less than expected at minus 5.4% (annualised). While the better than expected outcome was driven by a one-off boost to government consumption, which has been blamed on the outgoing Dilma administration’s attempt to salvage its government, there are other signals to suggest that the worst could be over. Business confidence and fixed asset investment growth remain at historic lows, but the rate of contraction was slower in the first quarter of this year.”

Inflation is also sitting at a multi-year high (9.3% year-on-year in April), although it is expected to soon peak due to the impacts of the base effect and lower economic activity.

“Potentially, this will give Brazil’s central bank more room to support the economy and cut interest rates. Under the scenario of ongoing market reforms and falling inflation these forces would create a positive environment for an equity market that has sold off significantly. However, we are not yet convinced that these trends have taken hold. Brazil is starting to look more interesting, but it is not out of the woods yet,” said Fu.

However, Nikko Asset Management said in a research note it was too early to invest in Brazil for the long term. The multi asset team reported: “Although there may be tactical opportunities (particularly in bonds and the currency) in the medium term. Brazil will remain vulnerable to ongoing volatility in the commodity space, but Robert Samson’s concern is more for the long term as deteriorating fundamentals may accelerate pas the political system’s capacity to address them.”

FLOWS INTO BROAD EM

While single countries largely remain out of favour, the uptick in broad emerging markets performance has prompted flows to return.

Samadder said: “The flows have gone into broad markets and this is because at the moment that is the best way to capture the whole theme. We’d recommend to buy broadly and then specify a granular view.

“While emerging markets have historically been seen as a risky asset class the actual realised  index volatility of the MSCI EM Index over the last 10-years has been lower than most developed regions, including MSCI Europe, Topix and MSCI Pacific ex Japan.”

However, while he believes flows will continue, Samadder warns that “they can reverse quickly.”

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