The world has spent much of 2020 trudging through the trenches, but with less than two months to go before we bring down the curtains, the recent vaccine-related news from Pfizer (PFE), AstraZeneca(AZN), and Moderna (MRNA) feels like the proverbial light at the end of the tunnel. It remains to be seen if things will ever be the same again, but perhaps it wouldn’t be too unreasonable to expect “some semblance” of economic normality in 2021? December also seems to be the month when a lot of investors re-position their portfolios; with the S&P 500 (^GSPC) currently trading at an exorbitant P/E of 40x, and the Nasdaq 100’s (NDX) valuations not far behind at 36x P/E, it’s challenging to make a case for further outsized gains from the domestic markets. There are various alternatives that offer more compelling value at current levels, but in my piece today I’d like to touch upon the emerging markets and do a comparison of two emerging markets ETFs that you may consider.
Why you should be rotating into EMs
On paper, from a growth perspective, emerging markets (EM) are meant to be something akin to the return and volatility profile of high-beta stocks/funds, i.e. they tend to deliver above-average figures both on the upside and on the downside; except this year, in 2020, when we’ve had a downturn, emerging markets on average have fared a lot better than the world, and the advanced economies (developed markets or DM). As per the latest IMF forecast (Oct-2020), EMs will finish 2020 with a real GDP decline of -3.3% vs. -5.8% for DMs, and -4.4% for the world.
EMs have been able to cushion the fall because a sizeable chunk of these EMs are based in East and South Asia, and enjoy some rather resplendent tech and medical supplies/equipment manufacturing credentials. The health pandemic and associated lockdowns have raised the need for home entertainment, remote working capabilities/gadgets, data center equipment, health, and safety equipment, etc., a bulk of which tends to be manufactured and exported from foundries based in China, Vietnam, Taiwan, and South Korea. EMs with this sort of expertise should continue to enjoy steady growth prospects, but going forward we might see a passing of the baton towards commodity-driven EMs such as South Africa, Brazil, Saudi Arabia, and Russia.
The world is awash with liquidity, and in 2021 a lot of governments will attempt to restimulate their respective economies and the general employment level by indulging in infrastructure-themed projects. This should help ramp up demand for industrial commodities. Also, with the vaccine progress underway, one should see some normalization of previously hindered activities such as travel and leisure in 2021, and this should boost the prospects of energy and energy-reliant EMs.
2020 has shown us a lot of things, but one theme that has cropped up recently is this increasing need for food security. Whilst the recent vaccine-related news is encouraging, it will still take a while before it can be produced in mass, and then be transported and distributed at an affordable cost across the globe. This may not be plain sailing and a delay here may continue to keep virus cases elevated and also result in ongoing lockdowns. On account of this, one is likely to see various governments building their food buffers and hoarding food stocks. This is likely to keep demand for agri-commodities elevated and EMs with strong agri-themes such as Brazil, Russia, Thailand, India, etc. should benefit.
Another potential tailwind in 2021 could be the dollar. As risk appetite gains steam, safe-haven assets such as the dollar will likely lose steam. We also saw the Fed recently tweak its inflation targeting strategy enabling the inflation rate to overshoot the 2% mark. This basically suggests a prolonged period of dovishness, which should result in lower real rates and a depreciation of the dollar over time. I can appreciate there are a lot of dollar bulls around who don’t agree with this thesis, but with the total public debt at a ludicrous $27 trillion and public debt to GDP at 135%, it’s difficult to see a further appreciation of the dollar.
Source: Visual Capitalist
A potentially lower dollar in 2021 should aid EMs; a lot of these EM economies have built up strong dollar-denominated liabilities (estimated to be $4 trillion) and could do with a breather in the form of dollar depreciation. This should also result in greater capital flows to the EMs.
All in all, going forward in a potentially more salutary growth environment, EMs are expected to churn out above-average GDP growth rates, well ahead of the world average, and the advanced economies.
Source: Prepared by the writer using data from the IMF
On a factor basis, the real GDP growth potential of EMs relative to the world average is currently less than 1x (0.75x for 2020) but this is expected to expand every year over the next 5 years and hit a factor multiple of 1.34x, highlighting the potential for expanding outsized growth relative to the norm.
Source: Prepared by the writer using data from the IMF
Emerging markets ETFs – IEMG vs. SCHE
When it comes to EM equity ETFs, I’ve noticed that the two ETFs that get bandied around a lot by financial advisors are the Vanguard FTSE Emerging ETF (VWO) and the iShares MSCI Emerging Markets ETF (EEM). Perhaps it is because these two ETFs are stalwarts, with a long history exceeding most, if not, all the other EM ETF alternatives – VWO has been around since 2005, and EEM has been around since 2003. I have nothing against these two ETFs, but in this article, I’d like to put forward two other lesser known alternatives for investors to consider – 1) The iShares Core MSCI Emerging Markets ETF (IEMG) and 2) The Schwab Emerging Markets ETF (SCHE). Both these ETFs are reliable performers and share a lot of similarities, but there are also some key differences that I want to highlight and this may help aid your selection. Here are some of the key takeaways from my comparative analysis-
AUM – This may well be on account of Blackrock’s (NYSE:BLK) superior brand image and marketing expertise (relative to Schwab (NYSE:SCHW)), but despite being around for a much shorter duration (IEMG was established in Oct-2012 whilst SCHE was established in Jan-2010), IEMG has managed to amass a far superior AUM over the years, almost 8x SCHE’s current AUM of $7.82bn.
Cost – From an efficiency perspective, both ETFs offer remarkably lower expense ratios (bettered perhaps only by VWO at 0.1%) but SCHE has a slight 0.02% edge.
Liquidity- IEMG’s relative popularity also means that it tends to be more liquid (90-day average daily volume of 13m shares vs. just 1.36m for SCHE). This consequently results in lower spreads of only 0.02% vs. 0.04% for SCHE. Thus, if you’re someone who’s not in it for the long haul, and wants to make regular rotations into and out of EM ETFs, or only use it as a short-term trading vehicle, then IEMG should be your preferred vehicle.
Holdings and concentration- IEMG offers you a larger pool of close to 2500 stocks, whilst SCHE only offers you access to 1500 stocks. Yet still, despite a difference of almost 1000 stocks, the weight of the top-10 is not too different with both close to the c.30% mark. This would imply that quite a few stocks outside the top-10 of IEMG are in effect just making up the numbers, and not contributing much. The top 3 names and their respective weights too are similar. On account of favorable domestic demographics and the ever-growing penetration of tech and e-commerce, the long-term prospects of Alibaba (BABA) and Tencent (OTCPK:TCEHY) look very enticing, but in the near term, these two companies, especially the former, may have to contend with some regulatory challenges. TSM is on course to deliver another solid quarter in Q4 and remains a key agent in the growing tech influence of 5G, Cloud computing, and IoT.
Sector exposure – Both the ETFs have significant and identical exposure to the consumer discretionary sector which is the top sector- this sector will serve as a useful proxy for improving employment and income levels in the emerging markets. Financials and tech are the next two key weights for both these ETFs, and in this case, I like SCHE’s mix better; I just feel that the tech trade is an overbought trade , and at this juncture, you want to be more exposed to the more value-oriented financials segment which will be faced with a better macro landscape in 2021. The income component of financials too tends to be better than tech and the additional income will be useful in case capital appreciation is hard to come by.
Tracking index – Despite the common EM focus, both these ETFs track different indices. IEMG tracks the MSCI Emerging Markets Index, whilst SCHE tracks the FTSE Emerging Index. The latter does not consider South Korea to be an emerging market, which means by pursuing an investment in SCHE you’re likely to miss out on South Korean exposure, whereas IEMG gives you exposure of around 13%. Personally, I’d like some exposure to South Korea as domestic demographics are enticing and the government there has also shown great dexterity in handling the virus; tech exports to continue to remain resilient and I expect the Biden regime to be beneficial for trade-reliant nations such as South Korea who derive 40% of their GDP through exports. Worth noting that recently the country reported its steepest quarterly increase in GDP in Q3.
Key geographies – A lack of South Korean exposure for SCHE means the relative weights of China and Taiwan get bumped up (both these regions account for more than 60% of the holdings) and India takes the third slot (c.10% weight). With IEMG these weights are more well-spread out with China accounting for c.38%, Taiwan c.13%, and India c.8%. Regardless, what’s common between both these ETFs is that despite being an EM play, there is a clear thrust towards EM-Asia in general. About 80% of IEMG’s holdings and 83% of SCHE’s holdings are based in Asia. I wouldn’t worry too much about that as prospects for the EM-Asian countries look a lot more encouraging than those based in other regions. As you can see from the table below, growth forecasts for EM- Asia in 2021 look the strongest.
Source: S&P Global
Dividend profile – There’s nothing to choose between these two ETFs when it comes to their dividend credentials with both offering a useful yield of almost 3%, and also displaying similar historical dividend growth rates. Where they differ is with regards to the timing; if you’re someone who is on the lookout for more frequent dividends, IEMG should be your choice as they pay dividends semi-annually (in effect, the annual dividend payout for both are roughly the same).
Valuations- From a historical P/E valuations perspective both are available at a similar range of around 16-16.5x, but from a forecasted P/E perspective, SCHE is the slightly more expensive one. Given SCHE’s better risk-adjusted returns track record (more on that below), and lower efficiency costs, this edge in the valuation could perhaps be justified.
Source: Prepared by the writer using data from Seeking Alpha, YCharts, SCHE and IEMG
Risk-return track record- As you can see from the table below, both ETFs deliver superior risk-adjusted numbers to their peers, but when you compare the two, SCHE comes out on top. SCHE has been able to generate superior alpha of almost 3.5% vs. sub 3% for IEMG. Relative to your average ETF, EM ETFs tend to be volatile and this is reflected in superior betas although, SCHE’s is slightly lower. From a total risk perspective too (standard deviation), SCHE has a lower figure, implying lower volatility in general. On account of the slightly lower risk, SCHE has been able to deliver superior excess returns (returns over the risk-free rate), both from a Sharpe ratio perspective (measures excess returns per unit of total risk) as well as Treynor ratio perspective (measures excess returns per unit of systematic risk). The other key takeaway is from the r-square. As you can see, most other ETFs (category average) don’t do a particularly good job in tracking their respective benchmark indices with a relatively low r-square of 75%. IEMG and SCHE are both better at this, but crucially despite having the lower r-square of the two, SCHE throws up better risk-adjusted stats (Alpha, Treynor, Sharpe); this could mean two things – 1) the index that IEMG tracks – MSCI Emerging markets index – is less adept at generating returns, and/or 2) SCHE’s stock selections that differ from SCHE’s tracking index (FTSE Emerging Index) have been crucial in delivering a superior return.
Source: Prepared by the writer using data from Yahoo Finance
Price action – There are a lot of similarities between the charts of SCHE and IEMG. Since 2018, both ETFs had been drifting lower in the shape of a descending broadening wedge pattern. IEMG broke out of the upper boundary of its wedge in August and spent two months hovering below the previous resistance below the $55 mark. In November, we saw a decisive green candle surge past this resistance and currently, the ETF is about 8% away from its all-time high. With SCHE, similar price action regarding the wedge upper boundary and previous resistance of $28 has been seen. However, November’s breakout candle is less than 4% away from the previous all-time highs. The current momentum is strong with both ETFs trading above the 50, 100, and 200-DMA s (Moving Averages), that said purely from a price action point of view the risk-reward is not the most ideal, as we are close to previous hurdles.
Source: Trading View
Source: Trading View
Both SCHE and IEMG are competent, reliable ETFs that allow investors to exploit the favorable dynamics in emerging markets. However on account of its lower efficiency ratio, its greater exposure to the undervalued financials segment, and its superior risk-adjusted track record, I would be inclined to side with SCHE.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.