The Argument For Emerging Global’s ECON
In my monthly interview with Olly Ludwig, I called ECON the new face of emerging markets. Here's why.
Emerging markets have been hit with the ugly stick recently. The iShares Core Emerging Markets ETF (IEMG), our favorite broad-based emerging markets ETF, is trading down about 9 percent year-to-date, even as the SPDR S'P 500 ETF (SPY) is up nearly 19 percent.
But not all flavors of emerging markets have been hit equally. For one, different countries have been behaving differently:The iShares MSCI Philippines ETF (EPHE) is up nearly 5 percent year-to-date, while the iShares MSCI All Peru Capped ETF (EPU) is down nearly 30 percent.
But more interestingly, different approaches to broad-based emerging markets have been delivering different patterns of return. The two most interesting alternatives in my mind are the PowerShares FTSE RAFI Emerging Markets ETF (PXH) and the EGShares Emerging Consumer ETF (ECON).
Neither has been tearing it up exactly. ECON has managed to lose "just" 0.86 percent on the year, while PXH is down a whopping 12.56 percent.
Going forward, though, I think there are reasonable—if opposing—arguments for both funds.
PXH:A Value Play
The argument for PXH is simple. This fundamentally weighted ETF takes the FTSE Emerging Markets Index and, instead of weighting companies by their market capitalization, weights them by fundamental measures like sales, earnings and dividend yields. The resulting portfolio strongly overweights energy stocks (22 percent versus 10 percent for IEMG) and telecoms (11 percent versus7 percent), but the real story comes in the valuation metrics. With a price-to-earnings ratio below 10, a book value near 1 and a dividend yield that's a point higher than IEMG, PXH is compelling from a pure value perspective.
Emerging Markets Valuation Comparison | |||
IEMG | PXH | ECON | |
Weighted Average Market Cap | $37.11B | $48.76B | $28.98B |
Price/ Earnings Ratio | 12.34 | 9.44 | 22.87% |
Price/ Book Ratio | 1.4 | 1.02 | 3.51 |
Dividend Yield | 2.55% | 3.51% | 1.59% |
ECON:For The Long Term
The argument for ECON is more nuanced and interesting—and more or less contrary to the argument for PXH.
The forthcoming September/October issue of the Journal of Indexes ( subscribe for free here !) features an amazing article by Tyler Mordy, chief investment officer of Hahn Investment Stewards, and one of my favorite macro-focused investors. In the article, titled "The Unbearable Lightness of the Central Bank Put," Mordy lays out a roadmap for investors for the next five-plus years.
I won't spoil the whole thing, but I will excerpt one of my favorite sections. In just 137 words, Mordy captures a concept that I think could significantly shift assets in the emerging markets space in the years to come:
"The living standards of select developing nations are converging with that of the developed nations. On a GDP per-capita basis, the average American was 22 times richer than the average Chinese citizen in 1978. Today that ratio is down to only 5 times.
Investors should own shares in companies that are exposed to the ongoing transformation in the developing world and that can leverage the rising demand for consumer goods and services. That isn't limited to Western multinationals, but should also focus on select emerging market sectors. However, generally, the same stock market sectors that should be underweighted in the West should be overweighted in most emerging markets (i.e., positioned to benefit from a rising middle class). Beware of broad-based emerging-market equity ETFs, as much of their indexes are geared toward the exporting component of their economies."
That last sentence is particularly powerful. The emerging markets boom of the past decade has been driven primarily by large, multinational companies exporting raw materials and low-value consumer goods to the developing world.
As the developed world grinds through this period of slow growth—and as central banks engage in widespread currency devaluation in an attempt to reinvigorate national economies—these export-driven firms should suffer. That is certainly part of the explanation for the widespread pullback in emerging markets stocks this year.
Amidst this pullback, however, the broader trend of an emerging middle class remains intact. Labor continues to shift into emerging markets, education continues to increase and wages there continue to rise.
McKinsey ' Company projects that Chinese consumer demand will grow by 10.3 percent per year over the next decade. Against this backdrop, ECON—with its pure-play exposure to the consumer sector—shines.
[ Editor's Note: This updated table reflects corrections in the Basic Materials and the Consumer Non-Cyclicals rows.]
Emerging Markets Sector Breakdown | |||
IEMG | PXH | ECON | |
Financials | 27.05% | 27.90% | 0.00% |
Technology | 14.48% | 10.87% | 0.00% |
Consumer Cyclicals | 10.43% | 5.10% | 45.28% |
Basic Materials | 10.31% | 12.29% | 0.00% |
Energy | 10.04% | 22.09% | 0.00% |
Consumer Non-Cyclicals | 8.45% | 3.51% | 54.72% |
Telecommunications Services | 6.98% | 10.99% | 0.00% |
Industrials | 6.90% | 3.66% | 0.00% |
Utilities | 3.33% | 3.46% | 0.00% |
Healthcare | 1.99% | 0.13% | 0.00% |
Are there risks? Of course there are.
ECON is an expensive ETF. It costs 0.85 percent in annual expenses and, on average, ECON trailed its index by 1.04 percent per year over the past two years. Its tracking variability is larger still, with wide ranges of tracking performance.
The portfolio is also narrow, holding just 30 names and putting an awfully large weight in top holdings like South Africa-based Naspers Ltd. (10.19 percent) and the Brazilian Companhia de Bebidas das Americas (9.09 percent). Its stocks are already trading at high valuations (P/E of 22!), and the ETF is exposed to currencies of questionable strength, including the South African rand, the Brazilian real, etc.).
Does it make sense as a whole-scale replacement of core emerging markets exposure? I wouldn't be so bold. But I'm guessing more and more investors are considering whether it should represent a portion of their portfolio in the years to come.
In my personal portfolio, I'm still sitting on IEMG. As readers know, I'm one of the most boring investors around:I firmly believe in broad-based indexing, and I change my portfolio slowly and reluctantly, if at all. Still, I'll be watching ECON, as the big-picture macro view is intriguing.
At the time this article was written, the author held no positions in the securities mentioned. Contact Matt Hougan at mhougan@indexuniverse.com.
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