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Chasing Returns in Emerging Markets

Patricia Oey

PowerShares DWA Emerging Markets Momentum Portfolio (PIE) is currently the only fund to offer a momentum strategy in emerging markets. Momentum strategies seek to capitalize on the phenomenon that securities that have recently outperformed will continue to do so in the short run, and those that have underperformed will continue to lag. This passively managed fund tends to perform best, relative to the cap-weighted MSCI Emerging Markets Index benchmark, when there is a large difference between the best- and worst-performing emerging-markets countries. This fund also does not have some of the drawbacks of a cap-weighted index fund--namely, a consistent, significant exposure to government-controlled entities and global cyclical firms.

At first glance, a momentum strategy in emerging markets seems appealing, both on its own merits and relative to a cap-weighted approach. The emerging markets are composed of about 20 countries, each with very distinct economic, political, and social environments. As a result, these countries can have widely divergent stock market performance--for example, in 2011, the MSCI Indonesia Index was up 6%, whereas the MSCI India Index was down 37%. This fund, which tracks an index with no sector or country constraints, can capitalize on these differences. So, in 2011, the fund had an overweighting in Indonesian stocks (with a 13% allocation versus 2% for the MSCI Emerging Markets Index), and an underweighting in Indian equities (0.5% versus 6%). This, along with other momentum-based bets, resulted in a negative 11.4% return in 2011, a significant outperformance relative to the MSCI Emerging Markets Index’s decline of 18.4%.

However, momentum is a high turnover strategy, one which can be particularly difficult to execute in emerging markets, where liquidity is lower and transaction costs are higher. Through Sept. 30, 2013, the fund's five-year annualized returns were 6.4%, significantly trailing its index's 10.6% over the same time period. This figure included 2009 returns, when the fund rose 59.6%, but when the index climbed 69.3%. These large performance gaps were partly due to the fact that the fund, at times, could not acquire certain illiquid small- and mid-cap index constituents. In late 2011, the index incorporated a more stringent liquidity screen. The implementation of this screen appears to have improved the fund's tracking. PIE trailed its index by 77 basis points in 2012 and 55 basis points for the year to date through Sept. 30, 2013. While it is possible that the new liquidity screen may result in better tracking, it may also hinder the fund's performance relative to prior years if it were the case that the less-liquid names in the index were contributing to the strategy's alpha. At this time, it is too soon to draw this conclusion.

Over the past five years, this fund's standard deviation of returns of 23% was in line with that of the MSCI Emerging Markets Index. During relatively calm markets, this fund tends to be less volatile than the MSCI Emerging Markets Index. However, during periods of high market volatility, momentum strategies become extremely fickle and can significantly underperform. Following the 2008 global financial crisis, this fund saw a maximum drawdown of 69.4%, which was significantly higher than the MSCI Emerging Markets Index's decline of 58.8%. Given the potential volatility of this strategy, this exchange-traded fund is suitable for use as a satellite holding by very risk-tolerant investors.

Portfolio Construction
This fund tracks the Dorsey Wright Emerging Markets Technical Leaders Index. The index selects 100 stocks using a measure of relative strength, or a stock's performance relative to a universe of about 1,000 stocks. Securities with better short-term relative strength characteristics are given relatively higher weightings, and the index is reconstituted quarterly. There are no country or sector constraints, so this fund's portfolio can look very different from the MSCI Emerging Markets Index.

Dorsey Wright, an investment advisory firm, has not provided a methodology document for this index, so additional details regarding the index's relative strength indicators are not available.

On Oct. 4, 2013, the fund underwent a name change from PowerShares DWA Emerging Markets Technical Leaders Portfolio to PowerShares DWA Emerging Markets Momentum Portfolio. There was no change to the index or the index methodology.

This fund carries an expense ratio of 0.90%. Annual turnover for this fund is extremely high, averaging 152% over the past three years. Given the high turnover, this fund is more likely to distribute capital gains relative to low-turnover passive strategies, as some emerging-markets countries do not allow for in-kind transactions. In-kind transactions allow ETF portfolio managers to remove securities from a portfolio by transferring them on an in-kind basis to an authorized participant instead of selling them outright, which can result in distributable capital gains. So far, this ETF has never distributed capital gains.

Among passive strategies, we prefer dividend or low-volatility strategies over cap-weighting for emerging markets.

Our favorite emerging-markets dividend fund is WisdomTree Emerging Markets SmallCap Dividend (DGS). Even though this is a small-cap fund, its volatility has been lower than that of the MSCI Emerging Markets Index. This ETF charges 0.63%. There are two other dividend-focused options, both of which have a mid-cap tilt. SPDR S&P Emerging Markets Dividend (EDIV) holds 100 high-yielding stocks and was launched in February 2011. Holdings must have had positive three-year earnings growth and profitability and are weighted by dividend yield. The fee is 0.59%. IShares Emerging Markets Dividend Fund (DVYE) was launched in February 2012. This ETF selects and weights companies based on dividend yield. Holdings must have had positive earnings over the past 12 months and paid dividends each year over the past three years. This ETF charges 0.68%.

Our favorite low-volatility option is iShares MSCI Emerging Markets Minimum Volatility (EEMV) (expense ratio 0.25%), which holds a portfolio of stocks culled from the MSCI Emerging Markets Index that has the lowest absolute volatility with a given set of constraints to maintain diversification. Low-volatility strategies seek to exploit the observed phenomenon that portfolios with smaller price fluctuations tend to outperform portfolios with larger price fluctuations over the long term.

Patricia Oey does not own shares in any of the securities mentioned above.

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