A Top Emerging Market Fund Emerges

01/19/2012 9:00 am EST

Focus: ETFs

One of the best places to find income is in strong emerging markets, and this ETF is holding some of the best paper around, writes Patricia Oey of Morningstar ETFInvestor.

We like WisdomTree Emerging Markets Equity Income’s (DEM) dividend-weighting methodology, because its portfolio is significantly less volatile than a market-cap-weighted emerging markets portfolio.

Dividends are also a straightforward measure of value that is not affected by variances in accounting standards across countries. The 3% annualized return of this ETF’s underlying index since its inception has been about 600 basis points higher than that of the MSCI EM Index. This outperformance, combined with DEM’s relatively lower volatility, suggests that a dividend-focused strategy could be a viable strategy in emerging markets.

DEM’s dividend strategy may also reduce valuation risk. By anchoring bets to a fundamental valuation measure and rebalancing the portfolio once a year, value strategies like DEM’s may earn excess returns by avoiding overpriced companies and sectors. This ETF usually trades at a lower trailing 12-month P/E ratio relative to the MSCI Emerging Markets Index.

DEM is our pick for passive, emerging-markets exposure and is suitable as a small core holding. While global markets tend to be more correlated when sentiment is bearish, emerging-markets equities can decouple from developed-markets equities during market recoveries.

We also highlight that emerging markets will continue to grow in size and importance in the coming years, and emerging markets equities can also help hedge against expectations of a weakening dollar in the longer term.

While this fund is significantly less volatile than the MSCI Emerging Markets Index, it is still risky, as emerging-markets equities and currencies can see steep declines when global market volatility is high. DEM, like most ETFs that invest in international equities, does not hedge its foreign currency exposure, so in a “risk-off” environment, emerging-markets investors suffer from both falling asset prices and falling currencies.

Our long-term outlook for this fund is positive. As the developed world continues to face slow growth in the near term, emerging economies should benefit from a number of long-term growth drivers such as new infrastructure construction, higher-value manufacturing and services exports, and rising domestic consumption.

And in the near term, most emerging markets have more leeway to adjust their monetary and fiscal policies to support growth, and inflation risks have ebbed. We think the companies in this fund are well positioned to benefit from these trends. Should global volatility recede to more normal levels, we think current low valuations and potential proactive stimulus measures should support improving emerging-markets performance in 2012.

In addition, most emerging markets have healthy budgets, high levels of foreign reserves, and attractive growth outlooks, and they will likely enjoy investment inflows. This will likely support appreciating currencies over the long term.

However, there are near-term risks that should not be overlooked. Periods of very high global market uncertainty (such as an escalating Eurozone crisis) tend to have an outsized negative impact on emerging markets. In addition, slowing global growth will weigh on emerging markets, many of which are export-oriented economies.

This ETF has heavy weightings in Brazil and Taiwan, each of which account for about 20% of DEM’s portfolio. These country weightings are notable because, in the past few years, Brazilian and Taiwanese companies have benefited significantly from their growing exposure to China. So, this fund’s 3% weighting in Chinese companies somewhat understates its overall exposure to demand growth in China.

At this time, the Chinese government remains committed to maintaining high-single-digit GDP growth, but it will be a difficult balancing act in the near term. With slowing demand from its export markets, China will need to focus on domestic consumption without reflating an asset bubble, maintain control over the yuan exchange rate, and ensure stability in its banking and real estate sectors.

The China demand tailwind for Taiwanese and Brazilian companies will likely ebb in the near term. Aside from China, Taiwanese companies may be negatively affected by slowing global growth, as exports account for 62% of Taiwan’s GDP.

However, 50% of this fund’s Taiwanese holdings are technology firms, which are positioned to capitalize on rising penetration of smartphone and tablet use, especially in the emerging markets.

In Brazil, DEM’s holdings are mainly in financials, consumer staples, and utility companies. Recently, the Brazilian government has started to move forward with fiscal and monetary stimulus to address slowing growth, which may be a positive for Brazilian markets.

In the medium term, planned domestic infrastructure spending ahead of the 2014 World Cup and 2016 Summer Olympics may also provide a boost to Brazil’s industrial and material firms, as well as employment and consumer spending.

DEM tracks the performance of the top 30% highest dividend-yielding stocks from the WisdomTree Emerging Markets Dividend Index. The stocks are weighted based on annual cash dividends paid (as opposed to dividend yield), tilting the index toward large-value companies. The index is rebalanced annually in June.

This fund’s expense ratio is 0.63%, which is cheaper than other fundamentally weighted emerging markets ETFs.

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