Emerging Markets Have Room to Rise. Just Be Careful When Choosing an ETF

Photograph by Calvin Hanson

After a decade of virtually all asset classes marching relentlessly higher, there remains a holdout—emerging markets. While the S&P 500 index has racked up an annualized rate of 13.6% for the decade ending in 2019, the MSCI Emerging Markets Index has returned just 3.7%. As investors and analysts all expect more muted gains going forward, emerging markets may be one asset class that still has room to run.

At first glance, it would seem that exchange-traded fund investors have no shortage of options: There are 79 emerging-market stock ETFs. But choosing one isn’t simple. About half of those are traditional, capitalization-weighted indexes, and the rest use a variety of strategies to determine which stocks are held and in what amounts. What’s more, there are differences in the countries included that can lead to significant differences in returns. And it’s hard to make comparisons, since just a dozen have 10-year records, while 42 were launched within the past five years.

Another wrinkle: One of the most established emerging market ETFs isn’t a good option. The $29 billion iShares Emerging Markets ETF (ticker: EEM) holds 1,000 stocks, and returned 18% last year. But its 0.68% expense ratio is more than four times that of comparable funds—including the $62 billion iShares Core MSCI Emerging Markets (IEMG), which has almost 2,500 stocks and charges just 0.14%.

For broad-market exposure, the iShares Core fund is a much better bet, along with the Vanguard FTSE Emerging Markets ETF (VWO), which owns 4,200 stocks and charges 0.12%.

The two ETFs didn’t perform equally last year: The Vanguard fund returned 20.4%, and the iShares Core fund returned 17.5%. The difference is probably attributable to South Korea exposure—the iShares fund has 12% of its assets in South Korean shares, and the Vanguard fund doesn’t own any. Last year, the MSCI Korea 25-50 Index returned a relatively meager 8.6%, according to Morningstar, hampering overall returns for the iShares Core ETF.

South Korea has the world’s 11th-largest gross domestic product, which qualifies it as a developed market, based on size. But MSCI characterizes South Korea as an emerging market because it lacks a “full 24-hour global/offshore currency market,” says MSCI spokesperson Melanie Blanco. FTSE counts South Korea as a developed market, so it isn’t in the Vanguard ETF.

The $4 billion SPDR Portfolio Emerging Markets ETF (SPEM) also has no exposure to South Korea, and returned 19% last year. Over 10 years, however, the SPDR fund has returned an annualized 3.9%, while the Vanguard ETF’s 3.5% lags behind it.

This time, the difference is attributable to exposure to other countries, industries, and specific stocks. The SPDR fund has about 2,000 stocks, less than half of what the Vanguard fund owns.

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Differences in when the ETFs added volatile Chinese A shares could have been a factor, as well, says Matt Bartolini, head of SPDR Americas Research at SPDR ETFs. The SPDR fund added Chinese A shares last September; Vanguard added them in November 2015.

Strategic beta funds present other issues. For example, dividend-oriented emerging market ETFs tend to have 20% or more of their assets in Taiwan, a country that usually makes up 15% or less of capitalization-weighted funds.

Dividend funds have trailed. The $2 billion Wisdom Tree Emerging Markets High Dividend ETF (DEM) returned 3.4% over 10 years. That shouldn’t discourage potential investors: Studies have shown that dividend strategies capture the value factor. And two firms focused on asset-class valuations—Research Affiliates and GMO—have argued that value-oriented emerging market stocks are the cheapest in the world.

Write to John Coumarianos at john.coumarianos@barrons.com