Roller Coaster Ride of Emerging Market ETFs Due to Structural Defects

Emerging Market Exchange Traded Funds (ETFs) have ended in positive territory but continue to suffer from structural difficulties not present in many developed market ETFs.

Emerging Market ETFs faced redemptions totalling $4.13 billion, but surged in the following eight weeks, reaching a net inflow of $2,81 billion for 2016 to date, according toBloomberg. These inflows coincided with the broader emerging market which experienced a 21 month record inflow of $36.8bn in March, based on estimates from the Institute of International Finance.

Exchange traded funds, which act as an index but trade like a stock, are meant to provide investors both exposure and diversification. Emerging Market ETFs, however, tend to suffer from several problems that developed market ETFs do not. As a result, although emerging markets generally have much higher growth rates than developed markets, they have lagged developed markets in recent years.

The first vulnerability of valuations in emerging markets is their high correlation to oil and other commodity prices. Historically, as commodity prices have gone down, so have valuations in emerging markets.

Their second weakness is often in the composition of the ETFs themselves. For example, while emerging markets are often a growth story, many ETFs include State Owned Enterprises (SOEs), sometimes comprising up to 30% of the entire portfolio. As SOEs are typically old economy enterprises and do not have shareholder returns as a top priority, the consumer growth story of the emerging market may not be reflected in that particular ETF. Accordingly, an investor should closely review the composition of the ETF to ensure that it is consistent to the investor’s objectives.

There are, however, ETFs which do not include SOEs and are focused on the consumer growth story of the underlying market. ECON (industry leading consumer goods and services companies) and EMQQ (emerging market internet stocks) are two examples of this. However, even these ETFs are down over the last couple years, despite the fact that the average annual revenue growth rates of their holdings are 8% and 40% respectively.

This could represent an undervalued opportunity or, as with the MSCI Emerging Market ETF (EEM), offer a superior, long term opportunity, just as the EEM has outperformed the S & P 500 since its inception..

Mike Bishop JD


Twitter: @futurebash