Emerging Market ETFs: Alternative Weighting Edition

Emerging markets have seen their importance to the global economy swell in recent years, as the developing markets of the world have become the primary drivers of growth not only in their home markets but in advanced economies around the globe as well. With many developed countries struggling to gain traction and facing elevated unemployment levels and mounting debt burdens, allocations to emerging markets have become increasingly critical – and increasingly large – components of any long-term portfolio.

Given both the surge in demand for emerging markets exposure and the impressive expansion of the ETF industry, it should be no surprise that ETFs have become popular as a way to access the emerging markets of the world. There are now more than 50 ETFs in the Emerging Markets ETFdb Category, with more than $106 billion in aggregate AUM. While many of these products offer country-specific exposure, the vast majority of that AUM total – close to $87 billion – is in two broad-based funds linked to the MSCI Emerging Markets Index, EEM and VWO.

For investors looking to establish exposure to emerging markets, there is a lot to like about these two ETFs; the benchmark includes about 800 individual securities in close to two dozen individual countries. The MSCI Emerging Markets Index offers exposure to every corner of the emerging markets economy, and EEM and VWO offer extremely cost efficient (VWO more than EEM) and incredibly liquid (EEM more than VWO) ways to replicate this benchmark.

But there are some potential warts on the MSCI benchmark as well. Perhaps the biggest potential drawback is the weighting methodology employed; the index in question is market capitalization-weighted, meaning that it gives the biggest weightings to the most valuable companies. Market capitalization weighting results in low maintenance and therefore efficient fund management, but it also creates a link between stock price and weighting within an index. That creates a tendency to overweight overvalued companies and underweight undervalued stocks, a habit that could obviously have an adverse impact on performance over the long run.

Emerging Markets + Alternative Weighting = PXH, EWEM, DEM

While cap-weighting remains the dominant strategy in terms of both investor recognition and asset allocation, innovation in the ETF industry has given investors a number of alternatives. The Rydex S&P Equal Weight ETF (RSP), which holds the components of the S&P 500 in equal proportions, has become a popular substitute to cap-weighted U.S. equity ETFs. The significant gap between RSP and funds such as SPY – the performance delta was approximately 600 basis points in 2010 – has highlighted the potentially significant impact of weighting methodologies.

For those looking to add emerging markets exposure but interested in avoiding the potential pitfalls of a cap-weighted strategy, there are similarly several ETF options available:

• PowerShares FTSE RAFI Emerging Markets Portfolio (PXH): This ETF is linked to an index that employs a RAFI weighting strategy, a methodology that has become increasingly familiar in recent years. PXH gives exposure to many of the same companies that make up EEM and VWO, but uses multiple fundamental measures of firm size to determine the allocations afforded. Specifically, book value, cash flow, sales and dividends are considered to calculate a “RAFI weight,” ensuring that the link between stock price and weight is broken.

• Rydex Emerging Markets Equal Weight ETF (EWEM): This fund is the emerging markets counterpart to the ultra-popular RSP; EWEM contains all the components of the MSCI Emerging Markets Index, but gives an equivalent weighting to each. The result is an ETF that has near perfect overlap with EEM and VWO, but a unique sector profile, breakdown among market capitalizations, and tilt towards individual economies.

• WisdomTree Emerging Market Equity Income Fund (DEM):This ETF is linked to a fundamentally weighted index that includes the emerging markets equities with the highest dividends yield. This strategy may have appeal to investors looking to enhance the current returns generated by the equity portion of their portfolio, or may simply be attractive because of the disciplined tilts towards stocks that exhibit attractive pricing multiples. DEM will generally have a tilt towards sectors of the economy that make significant distributions – and that may be underrepresented in cap-weighted products (such as telecoms and utilities).

Disclosure: No positions at time of writing.

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