A Way to Profit on Re-Emerging Markets

04/09/2013 9:00 am EST

Focus: GLOBAL

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

Expect to see a solid rebound in developing stock markets over the second half of this year, and watch this ETF, which tackles smaller plays where foreigners can't easily invest, writes Nicholas Vardy of The Alpha Investor Letter.

This month's recommendation combines two highly profitable asset classes—small-cap stocks and emerging markets—through the WisdomTree Emerging Markets SmallCap Dividend Index (DGS).
 
Emerging markets have gotten off to a slow start in 2013. While US stocks have soared this year, the largest emerging-market exchange traded funds (ETFs) have been stuck in the red.

Despite the weak start, much of the world's "smart money" expects emerging markets to be standout performers during the second half of 2013. A recent survey by Credit Suisse of more than 500 market participants, who controlled more than $1 trillion in assets under management, found that emerging markets were pegged as the top-performing asset class for 2013.

Although emerging markets underperformed the US markets over the past five years, they strongly outperformed the S&P 500 over the past decade, by a factor of at least 4:1. The rise of the emerging-market consumer is a global megatrend that will generate profits for companies—and their investors—for decades to come.

The best way to profit from this megatrend is to invest in emerging-market small caps. Small caps, in particular, offer greater growth and investment potential than large caps. They also offer a more direct play on local consumer sectors and local economies.

Importantly, emerging-market small caps offer a different country and sector mix compared to large caps, and I believe they will continue to generate better returns over the future.

Up until recently, the most common way for you to invest in emerging markets has been through large-cap index funds, like widely held Vanguard FTSE Emerging Markets (VWO) and iShares MSCI Emerging Markets (EEM).

As market cap-weighted indexes, these mainstream ETFs favor large companies. They are also less geared to domestic-driven growth trends, and they miss the boat as a play on the emerging-market consumer. DGS has greater exposure to companies that are driven by domestic demand, like consumer-related companies, industrials, real estate, and financial services.

DGS also offers access to small-cap stocks in emerging markets you could never invest in otherwise. While some of the larger emerging-market stocks trade directly on exchanges in the United States through ADRs, the smaller players that make up DGS never will.

And unlike market cap-weighted mainstream indices, DGS is based on valuation, dividend contribution, and a proven track record of dividend growth.

The countries represented in the top holdings include Poland, Turkey, Hungary, Brazil, and India. The average exposure to the BRICS represents less than 10% of the portfolio.

DGS overweights Taiwan and smaller emerging Asia countries like Thailand, Malaysia, and Turkey—due, in part, to quirks in local regulations. Taiwanese and Brazilian companies tend to make high dividend payouts. The mix also means that a small country like Chile has the same weighting as China, which is dominated by large state-owned enterprises.

The sector weightings also help explain part of DGS’ large outperformance compared to the MSCI Emerging Markets Index. Its single largest exposure is to banks and financials, which benefit from growing demand for credit, insurance, and other financial services as markets mature. The fund also has a high concentration in consumer and manufacturing equities, as well as industrials and information technology.

Since its inception, DGS has strongly outperformed its big brother, EEM. From its inception in 2007 through December 31, 2012, DGS ranked ninth in a group of 258 US ETFs and open-end mutual funds in the diversified emerging markets category. That means it beat approximately 97% of funds in the category.

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