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Can Emerging Market ETFs Defy U.S. Rates Hike? - ETF News And Commentary

Sweta Killa

With solid May job numbers, the prospect of the U.S. rates hike is now getting closer to as early as September instead of a later period as many had expected. This has raised worries over the emerging markets, which was the worst hit by the taper tantrum of 2013 that resulted in a huge capital flight.  

The end of a cheap and an abundant dollar era would pull out capital from these markets, creating trouble for most emerging nations. The impact of this is already being felt as the emerging market stocks fell for the twelfth day in a row on Tuesday, representing the longest slump since 1990. Indonesia, the Philippines, Thailand, Taiwan and Turkey are being hammered badly (read: Worried About Higher Interest Rates? Buy These Four ETFs to Profit).

As per the latest data from the Institute of International Finance, private capital inflows to the emerging markets will likely decline from $1,048 billion in 2014 to $981 billion in 2015, representing the lowest level since the global financial crisis in 2009. In particular, foreign direct investment is expected to be weak, falling from $586 billion to $528 billion due to lesser inflows to China and Russia.

China is witnessing a slowdown despite rounds of policy easing while the Russian economy is being badly hit by falling oil prices. Further, growth in emerging markets will likely slow for the fifth consecutive year to 4.3% in 2015 from 4.6% in 2014 and 5% in 2013, according to the International Monetary Fund.  

Though speculations for the rates hike resulted in a broad sell-off and capital outflows, the situation is not as worse as it was in 2013.

Rate Hikes: No More a Threat to Emerging Markets?

Many emerging economies are now in a better position to withstand the rising rate scenario thanks to improving economic growth, a number of pro-reform measures, narrowing current account deficits, building foreign reserves and falling inflation.

In fact, the two funds – Vanguard FTSE Emerging Markets ETF (VWO) and iShares MSCI Emerging Markets ETF (EEM) – that dominate the asset base for the emerging world, have gained 3.7% and 2.1%, respectively, in the year-to-date time frame amid interest rates hike concerns and struggling currencies. The returns are much higher than the broad market fund (SPY), which added only 1.9% in the same period (read: Commodity Currency ETFs in Trouble as Dollar Resumes Rally).

The lower oil price is benefitting many emerging nations as the majority of them import oil to a greater extent than they export the commodity. In addition, slumping currencies are making exports competitive, leading to higher profits and improving the countries’ trade balance. High growth potential, rapid pace of industrialization, urbanization as well as monetary easing policies would further fuel growth in emerging market economies leading to higher stock prices. The diverging policies between these nations and the U.S. are creating opportunities for investors in the emerging markets.

To make the case stronger, emerging stocks appear cheaper at the current levels when compared to the stocks of the developed world. With that being said, we have highlighted three emerging market ETFs that might have underperformed so far this year but could deliver handsome returns compared to their other cousins even if the rates rise. Each of these boasts a strong Zacks ETF Rank of 2 or ‘Buy’ rating, suggesting their outperformance in the coming months.

PowerShares India Portfolio (PIN)

The Indian economy has been improving substantially after the pro-growth government took office last May. With foreign exchange reserves of around $350 billion, India is on its way to becoming the world's fastest-growing economy as it grew a solid 7.5% in the January–March period, beating the 7% growth in China Index (read: Will the Third Rate Cut Revitalize India ETFs Rally?).

The current account deficit has narrowed sharply with RBI estimating it at around 1.5% of the GDP for fiscal 2014–2015, below 1.7% in fiscal 2013–2014. Inflation has eased substantially, falling to a four-month low of 4.87% in April, well within the central bank target of 2–6%. One way to tap the recovering Indian economy is with PIN. The fund provides exposure to the basket of 50 stocks selected from the universe of the largest companies listed on two major Indian exchanges by tracking Indus India.

The top two firms – Reliance Industries and Infosys – take double-digit exposure each while the other firms hold less than 7% share. From a sector look, the fund is tilted toward energy at 22.9%, followed by information technology (19.6%), health care (12.5%), and financials (10.0%). The fund has amassed $646.8 million in its asset base and trades in solid volume of around 1.4 million shares a day on average. It charges a higher expense ratio of 85 bps and has lost 0.14% in the year-to-date timeframe.

iShares MSCI South Korea Capped ETF (EWY)

After expanding at a weakest pace in six years, the South Korean economy picked up momentum in the first quarter of 2015. Policy stimulus, increased consumer spending, stepped up construction investment, falling unemployment and tumbling inflation are fueling growth in the Asia's fourth-largest economy, though low inflation is leading to fears of deflation. Being one of the world’s largest importers of oil products, South Korea will likely benefit from lower oil prices, which in turn would further boost investments and consumption (read: 3 Country ETFs to Outshine in 2015).     

Given encouraging economic trends that are likely to outweigh the negatives arising from the Fed rates hike, investors could focus on the $4.1-billion worth EWY, which is the most popular and liquid option to track the country’s equity space. The ETF follows the MSCI Korea 25/50 index, holding 109 stocks in its basket. Samsung dominates the fund’s return at nearly 21.4% while the other firms hold less than 4.5% of assets.

From a sector look, information technology accounts for more than one-third share while consumer discretionary, financials and industrials round off the next three spots with double-digit allocation each. The fund trades in average daily volume of 2.7 million shares and charges 62 bps in annual fees. It has added 1.1% in the year-to-date timeframe.

Schwab Fundamental Emerging Markets Large Company Index ETF (FNDE)

Though there are several ETF options available for investors looking for a well-diversified broad exposure to emerging markets, FNDE could be a good way to go. This fund uses fundamental factors, such as adjusted sales, retained operating cash flow, and dividend plus buyback, to weight securities rather than market capitalization by tracking the Russell Fundamental Emerging Markets Large Company Index (see: all Broad Emerging Market ETFs here).

In total, the fund holds 314 securities in its basket that are widely spread out across components with none of them holding more than 3.9% of assets. Energy and financials take the top two spots at 24% and 20%, respectively, closely followed by technology (14%), materials (10%) and telecom (10%). Chinese firms make for the largest share in the basket at 21.2% while South Korea, Taiwan and Russia round off the top five with a double-digit exposure each (read: 2 China ETFs Hitting All-Time Highs).

FNDE is less liquid and less popular in the emerging market space with AUM of $230.5 million and average daily volume of 104,000 shares. Expense ratio came in at 0.47%. The ETF is up 2.5% in the year-to-date timeframe.

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PWRSH-INDIA POR (PIN): ETF Research Reports
ISHARS-S KOREA (EWY): ETF Research Reports
SCHWAB-F EM LCI (FNDE): ETF Research Reports
VANGD-FTSE EM (VWO): ETF Research Reports
ISHARS-EMG MKT (EEM): ETF Research Reports
SPDR-SP 500 TR (SPY): ETF Research Reports
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