Don’t Overlook These Emerging Market ETFs

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August 9, 2016 1:07pm NYSE:VWO

Image of globeFrom David Fabian: In my experience as an investment advisor, most portfolios that utilize exchange-traded funds have an embedded “home country” bias.  This means that the majority of the underlying assets are focused in U.S.-centric stocks and bonds rather than foreign markets.


This trend has been further exacerbated in recent years by the outperformance of U.S. large cap stocks versus their international peers.  Many ETF investors have grown weary of the persistent lagging returns and heighted volatility of both developed and emerging markets.  As a result, they have underweighted or altogether eliminated these assets from their portfolios.

The chart below of the SPDR S&P 500 ETF (SPY) versus the iShares MSCI EAFE ETF (EFA) shows this trend in stark detail over the last five years.

Yet as valuations in U.S. stocks rise to new all-time highs, the expectations behind future returns have slowly diminished.  Research Affiliates recently updated their expected return calculator for a variety of asset classes, including both foreign and domestic stocks.  U.S. large cap companies are expected to generate anemic real returns of just 1% over a 10-year time horizon.  That’s compared to 6.2% for EAFE stocks and 7.7% for emerging market equities.


Source: Research Affiliates, Asset Allocation Expected Returns, 7/31/16.

While there is no guarantee of future performance, those with a long-term time horizon may wish to closely evaluate the role that international stocks play in their portfolio.  This task can be easily accomplished with the use of highly diversified and low-cost ETFs.  The hang-up for most investors is choosing the right fund for their portfolio and sizing it appropriately.

Selection

Rather than trying to pick individual countries or segments of the globe, the simplest tactic is to use a broad-based international stock fund as a core holding.  Examples include EFA or the Vanguard FTSE All-World ex-US Index Fund (VEU).  Both funds provide exposure to hundreds of individual companies outside the United States in a single, inexpensive, and liquid investment vehicle.

These core building blocks can then be enhanced with smaller tactical themes with even further growth potential.  For instance, emerging market equities have rapidly become one of the most talked about stories of 2016.  The Vanguard Emerging Market ETF (VWO) has achieved more than double the performance of SPY this year and recently hit new 52-week highs.

The iShares Core MSCI Emerging Markets ETF (IEMG) is another noteworthy substitute as well.  Top country allocations in this fund include: China, South Korea, Taiwan, India, and Brazil expressed through over 1,900 individual stock holdings.

Sizing

One of the more important considerations in this decision-making progress may well be total position sizing.  Investors should consider that international stocks have historically been more volatile than their domestic counterparts.

Conservative investors will likely opt for muted exposure that limits their susceptibility to sharper declines.  This may fall in the 5-15% of the total portfolio depending on individual preferences and experience.

Those who are comfortable taking on additional risk or are looking to meaningfully diversify their overseas holdings may want to significantly up that exposure.  Many global portfolios have as much as 30-50% of their total stock allocation in international equities.  For instance, the iShares MSCI ACWI ETF (ACWI) has 48% of its country allocation in foreign stocks.  ACWI stands for “All Country World Index”, which is a market-cap weighted composite of all global stocks.

The Bottom Line

Investing in international markets may seem like an uncertain proposition given the many failed breakout attempts over the last five years.  Nevertheless, these markets can offer diversified portfolios fresh growth opportunities and attractive comparative valuations to U.S. stocks.

The Vanguard Emerging Markets Stock Index Fund (NYSE:VWO) rose $0.27 (+0.72%) to $38.01 per share in Tuesday afternoon trading. The VWO has returned more than 16% since the start of 2016, more than doubling the return of the S&P 500 in the same period.

This article is brought to you courtesy of FMD Capital.


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