(12/01/15) Low Volatility Ways to Play Emerging Markets

Emerging markets ETFs have been under pressure on concerns about slower economic growth and the impact of pending actions by the Federal Reserve, explains Todd Rosenbluth in Standard & Poor’s The Outlook.

As of October 2015, the International Monetary Fund forecasted emerging markets and developing economies to grow 4.5% in 2016, higher than the 2.2% for advanced economies.

For those who want to stay invested in this style, but reduce their potential risk, low volatility ETFs might be appealing.

Through a rules-based approach, the index the ETF seeks to track chooses the stocks that have recently exhibited the lowest volatility.

But, of course, there are differences between these products that are worth understanding when determining if one or another makes more sense for you and/or your client.

iShares MSCI Emerging Markets ETF (EEM) is the most actively traded emerging market ETF; the ETF was down 7% year to date through October 24.

The ETF has 844 securities with the largest country exposure in China (24% of assets), South Korea (16%), and Taiwan (12%), while sector exposure is greatest in financials (29%), information technology (18%), and consumer discretionary (9%).

In contrast, iShares MSCI Emerging Markets Minimum Volatility (EEMV) was down only 3.6% this year. The ETF holds 258 stocks in the broader MSCI emerging markets index that have below average volatility.

The goal is to get a low volatility portfolio without introducing a potential concentration either by sector or country.

The resulting ETF has less exposure to China and South Korea, but more exposure to Taiwan and Malaysia

From a sector perspective, while the financials weighting at 29% is the same as EEM, the technology and consumer discretionary weightings were lower. Meanwhile, consumer staples and telecom services stakes were higher.

In addition to holding up better this year, EEMV outperformed EEM over the last three years (up 0.5% vs. a decline of 2.2%) and did so with less volatility.

PowerShares also has a lower volatility emerging market product, though it takes a different approach and rebalances on a quarterly basis, not a semi-annual basis.

PowerShares S&P Emerging Markets Low Volatility (EELV) holds the 200 least risky stocks in the broader S&P BMI Emerging Markets index, but does not incorporate any sector or country bands.

As such, exposure was relatively limited in China (4%) and India (3%) and much higher in Taiwan (23%). Looking to sectors, financials and consumer staples were overweighted, while technology was underweighted.

According to S&P Capital IQ, EELV's holdings are more attractively valued than EEMV's. However, more of EEMV's holdings have above-average S&P Capital IQ Quality Rankings.

It is still too early to have a good read on when emerging markets will recover from the 2015 doldrums.

However, we think a low volatility approach offers investors with a way to participate in the stronger growth prospects of emerging markets, while trying to reduce their risk profiles.