Emerging Markets: Too Cheap to Ignore?

10/01/2015 10:00 am EST

Focus: ETFs

Emerging-markets stocks have gone from the penthouse to the outhouse; have they gotten too cheap to ignore? asks Ben Johnson of Morningstar ETFInvestor.

Over the 10-year period ended September 8, 2010, the MSCI Emerging Markets Index experienced an annualized return of 11.74%. The S&P 500’s (SPX) (SPY) annualized return was negative 1.2% over this same span.

For the five-year period ended September 8, 2015, the MSCI Emerging Markets benchmark declined by 2.29% on an annualized basis, while the S&P 500 was in full-on bull market mode, gaining 14.78% annually.

Today, emerging-markets stocks are unloved, rife with risk, and (unsurprisingly) trading at their lowest levels since 2009.

Investors’ appetite for emerging-markets stocks has apparently waned. From September 2005 through January 2013, emerging-markets equity ETFs amassed $102 billion in cumulative inflows.

In the intervening two-plus years, over $15 billion has flowed out of these funds. Sentiment has soured on the basis of poor relative performance and fraying fundamentals.

Where to begin with the risks? China, of course. The whipsawing Chinese equity market has put the world on edge.

Nowhere are the ripple effects of slowing growth in China more evident than in Brazil. Brazil’s exports of everything from beef to iron ore have declined dramatically as Chinese demand has tapered.

Investors are growing evermore fearful of emerging markets, so is now the time to be greedy? Emerging-markets equity valuations are looking increasingly compelling, especially on a relative basis.

However, in light of the myriad risks they’re facing today, I’d say: almost, but not quite. While valuations are compressed, it’s impossible to say that the worst is behind this asset class and whether expectations of pain to come have already been priced into these markets.

As it stands today, we have a fair-sized bet in place that emerging-markets stocks will pick themselves up. This takes the form of our allocation to iShares MSCI Emerging Markets Minimum Volatility ETF (EEMV).

EEMV is my preferred option for emerging-markets equity exposure; I think it is the most palatable passive approach to a very volatile asset class.

EEMV is less risky than its broad cap-weighted peers by design. Its lower risk profile is also apparent by the composition of its portfolio, specifically EEMV’s tilt toward defensive stocks.

EEMV had 26.27% of its portfolio in defensive names and 36.87% in stocks Morningstar characterizes as cyclical as of August 31, 2015.

Large SOEs (most notably Chinese banks and insurance and energy firms) are also underrepresented. This lessens concentration risk as well as the risk associated with a class of entities that might not put maximizing shareholder wealth at the top of their to-do list.

Times like these are when a strategy like the one employed by EEMV earns its keep. For now, I’m more than comfortable with our positions in this fund.

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