How Can An Investor Manage Risk In The Emerging Markets Asset Class?

The case for committing a significant share of an equity portfolio to emerging markets is compelling, but how does an investor seeking to increase exposure to the asset class manage risk given that emerging markets stock indexes are over 40% more volatile than the S&P 500, and emerging markets stocks may be at a cyclical high point and poised for a sharp correction?

Emerging economies are confronted with an even greater inflation problem than in the U.S. and will likely have to tighten monetary policy to restrain inflation, which in many countries is running at double-digit rates. The best way to manage price risk is to build a core position over time, making a conscious effort to increase commitments when corrections take place. Using periodic price weakness to accumulate exposure is a strategy that would have worked well over the past five years. In the course of that overall uptrend, emerging markets suffered five separate corrections of at least 10% percent and two declines in excess of 20%.

What Are The Most Attractive ETFs For Investing In Emerging Markets Stocks?

ETFs and index funds are an attractive, low-cost way for investors to gain exposure to emerging markets. The argument is made that emerging markets are not as suitable for indexed investments because emerging markets are less "efficient" with respect to information and security pricing and "active" managers are more likely to outperform. That argument contradicts a basic premise of capitalization-weighted indexing (i.e., after investment costs, the average actively managed dollar by definition underperforms the index) and is not supported by the data, which show that approximately two-thirds of actively managed emerging markets mutual funds have underperformed their benchmarks on both a trailing five- and ten-year basis.

Today there are dozens of ETFs providing exposure to emerging markets. There are broad-based funds covering the whole asset class, regionally focused funds, and country-specific funds. There are funds based on (1) traditional, float-adjusted, capitalization-weighted indexes, and (2) alternative indexes based on "fundamentals" such as dividends, earnings, sales, and book value.

Exhibit 4 presents three broad-based emerging markets ETFs that are attractive for different reasons.

The Vanguard Emerging Markets ETF (symbol: VWO) is attractive for its 0.25% expense ratio—lowest of any emerging markets fund—and its broad diversification (964 holdings).

Though the fund is expensively priced at 0.85%, the PowerShares FTSE/RAFI Emerging Markets ETF (symbol: PXH) will be interesting to watch to see if it can replicate in real life the impressive backtested results of its underlying index. The creator of that index, Research Affiliates, run by investment guru Rob Arnott, believes that their "fundamental" approach to indexing produces more "alpha" (i.e., outperformance vs. a cap-weighted index) in emerging markets stocks than in any other asset class.

Lastly, the WisdomTree Emerging Markets High Yielding ETF (symbol: DEM), which is screened and weighted on the basis of dividends, is attractive for its high dividend yield of 5.1% and the solid backtested performance history of its underlying index.

Each of these vehicles, used in isolation or in combination, will likely prove to be an effective means of investing in emerging markets stocks, whose prospects over the next five years appear bright, just not as bright as the past five years.

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