Emerging markets ETFs have outperformed domestic funds for a decade. But in the last six months emerging markets (EM) funds have struggled. Inflation and credit tightening now have many investors worried. Is the period of strong growth on low inflation over?
The first thing to watch is the Fed's treasury bond buying program. Much of the money raised by the Fed's bond purchases during the second round of Quantitative Easing (QE2) has found its way to emerging markets, attracted by the higher returns. These inflows have been beneficial to EM. They provide funding for growth. But they also cause problems. Massive inflows means that there is too much money to be used productively. This adds to the problem of inflation. Policy makers have responded by raising interest rates.
What happens If the Fed slows its purchases of US government bonds? Investors can expect that fewer dollars will find their way to these markets. If this happens it will probably be good for EM investors. It will permit banks there to slow or stop rate hikes. It may enable stronger growth. But for now the Fed is buying and EM economies struggling.
The chart below compares the iShares MSCI Emerging Index Fund (NYSEArca: EEM ) with the domestic benchmark Standard and Poors Depositary Receipts (NYSEArca:SPY).
The chart shows the domestic benchmark SPY is outperforming EEM by almost 10%. The decline in emerging markets is happening in spite of a lower dollar during this period and continuing growth in EM economies. Although some emerging market countries peg the local currency to the dollar, dollar weakness tends to be positive for the performance of emerging markets ETFs because assets denominated in a local currency appreciate when the dollar declines.
The second thing for investors to keep an eye out for is any change in growth expectations for EM countries. Right now, growth is strong. The IMF forecasts 2011 growth of 6.5% for emerging market countries overall, compared to 2.5% forecast for developed nations.
The third thing to watch is general investor willingness to assume risk. What is a fair price to pay for EM growth? The answer to the question turns on the relative risk investors assign to EM when compared to developed economies. When investors have an appetite for risk they are willing to pay more for growth. Benchmark ETFs in China, India, Chile and other EM countries have traded at higher P/E multiples than comparable domestic benchmarks. Recently investors, possibly anticipating the end of QE2, have shunned the risk trade, causing the P/E's of EM ETFs to fall.
It is difficult to determine a stable and optimal P/E ratio for emerging market ETFs. Historically P/E ratios of emerging markets funds are lower than domestic funds due to greater perceived risk in EM. Right now P/E ratios for ETFs holding assets in EM countries are comparable to developed nations. The iShares MSCI Emerging Index Fund (NYSEArca: EEM ) for example has a P/E ratio of 12, compared to a P/E of 14 for the domestic benchmark Standard and Poors Depositary Receipts (NYSEArca:SPY). For some investors this is too high.
Finally, investors may discover additional reasons for EM exposure. Investors historically turn to emerging markets for diversity and to lower portfolio volatility. The assumption is that the performance of far-away markets is covariant with domestic performance. Some of this has changed as investors recently have found emerging markets funds to be increasingly correlated with domestic equities. This hase made emerging market exposure more about gearing: another way of adding to portfolio beta. So P/E ratios of emerging markets funds have come more in line with the domestic indexes.
The ETF family includes an impressive number of funds focused on emerging market economies. In addition to the broadly focused regional and super-regional emerging market ETFs like EEM and industry behemoth Vanguard MSCI Emerging Markets ETF (NYSEArca:VWO), there are ETFs dedicated to specific countries, from Russia to South Africa to Malaysia to Chile. The list below includes some of the most influential and largest diversified emerging markets ETFs and their expense ratios:
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