EDC: One To Consider In 2023 (NYSEARCA:EDC)

Investment Thesis

In this article, we will review whether emerging markets present a long-term investment opportunity. We will then consider if a leveraged ETF is the right choice for a higher return. There are a number of challenges and opportunities for developing countries in the coming years. We will review the valuation and charts of the iShares MSCI Emerging Markets Index Fund (EEM), Direxion Daily Emerging Markets Bull 3x (NYSEARCA:EDC), and the S&P 500 (SP500).

Challenges

One of the emerging market challenges is a slowdown caused by economic contraction in developed countries. Inflation due to high commodity prices has been a challenge for a number of emerging market countries. The strong U.S. dollar has been a headwind as well, as it raises the cost of dollar-denominated debt.

Opportunities

As China reopens its economy, business should slowly return to normal. China has shown signs of fiscal stimulus to help the economy get through the initial phases of reopening. Inflation continues to be a concern, though commodity prices have pulled back in the past six months and overall inflation has peaked in most countries. Opening up China should result in opening up the supply chain. Opening up the supply chain will help bring inflation to pre-pandemic levels. Valuations for emerging markets are cheap going back decades. The U.S. dollar has likely peaked, and if it has, then the concern with dollar-denominated debt will subside.

Valuation

The valuation for emerging market countries is below $12, while the valuation for the US is around $17. Emerging market valuations are just above valuation levels going back over a decade.

Among the countries with a higher weighting within the emerging market basket, the valuations are generally low, except for India.

Chart of EEM

The chart for EEM has trended lower for the past two years but has started to turn around in the last couple of months. Based on technical analysis, close above the cloud and close above $41.14 would be a conservative way to consider if one wants to allocate new money.

Ratio chart of EEM to SP500 shows over a decade of decline. S&P 500 has outperformed, but that might be about to change.

EDC Background

Direxion Emerging Markets Bull 3X is a three-times leveraged long ETF by Direxion that tracks MSCI Emerging Markets stocks. EDC invests directly or through derivative instruments in the stocks of companies operating across various industries and with varying market capitalizations. EDC seeks to track three times the daily performance of the MSCI Emerging Markets Index. According to the fund’s prospectus, “The fund invests at least 80% of its net assets (plus borrowing for investment purposes) in financial instruments, such as swap agreements, exchange-traded funds (“ETFs”) that track the index, securities of the index, and other financial instruments that provide daily leveraged exposure to the index or to ETFs that track the index. The index is designed to represent the performance of large- and mid-capitalization securities across 24 emerging market countries.

Ratio Chart

When EDC’s performance is compared to EEM’s over the last year, EDC has a decline that is roughly three times that of EEM.

Holdings

Well-known names are in the top holdings and the fund is well diversified across sectors, market capitalization and countries.

Fund Performance

As expected, the returns are terrible for the leveraged fund due to the decline in the emerging market fund.

Quant Ranking by Seeking Alpha places EDC at the bottom due to its terrible performance over short, mid, and long term.

Risks

When considering risks for emerging markets economies, the first one to consider is government or political risk. China being a recent example of government risks. Sri Lanka declared bankruptcy and number of other emerging markets economies are in perilous state due to bad economics, corruption and COVID. Currency risk is the next one. Even if the stocks do well, however, currency depreciation can take away all of the gain and then some just due to compounding effects of currency depreciation over time. Emerging markets including China are hugely dependent on trade with developed economies and a recession in developed economies would be a huge headwind. EDC is a leveraged investment vehicle and should be used either for daily or very short term timeframe. Three times leveraged products over time will underperform as shown in comparison of EEM to EDC and one has to be extra careful both in timing them but also limit oneself to less than a third of the position size when buying them.

Summary

While there are green shoots, the coming recession in developed economies makes it a bit early to buy into risky asset classes with new money. However, valuations for emerging market equities are at the bottom end. When we get favorable tailwinds from a weaker dollar and falling inflation along with growth in emerging markets, it will present an opportunity to invest in emerging markets. Since EDC is a leveraged fund, it would be best to buy once we have a confirmed uptrend in EEM and outperformance compared to the SP500. Until then, I would recommend being patient and not yet investing in EDC.