EEM: This ETF Does Not Include Important Underdogs

Article Overview

Emerging markets have had a poor year so far as equities have returned -20% YTD. In previous articles, I have mentioned some of the main issues that impact emerging markets, such as weaker economic growth, inflation, political risks, and rising sovereign debt risks. After a multi-decade underperformance from emerging markets, the remainder of the 2020s could be a period for select emerging markets to outperform global equities. Following the MSCI Emerging Markets Index could be an ok way to do this, but there is greater value in smaller emerging markets, primarily in Latin America, in my view. The divergence in valuation has increased a lot in the past years, so I think it is much more important now to selectively shop within emerging markets.

The iShares MSCI Emerging Markets ETF (NYSEARCA:EEM)

This ETF accurately tracks the MSCI Emerging Markets Index and invests in a basket of over 1,000 companies. This ETF is an interesting vehicle to consider due to the historical underperformance of emerging markets in the past decade. MSCI emerging markets have only returned around 11% since November 2007, while global equity markets have nearly doubled during the same period. Moreover, many emerging markets have underperformed the EM Index and I think there could be outsized returns if these markets mean revert.

Some of the ETF’s larger holdings, like Taiwan Semiconductor (TSM) and Tencent Holdings (OTCPK:TCEHY), are very volatile and tend to outperform during bull markets and underperform during short-term sell-offs.

Emerging market equities trade at 11.5x forward earnings, which is attractive given the industry composition of the MSCI Emerging Markets Index. This ETF has over half of its assets invested in themes like healthcare, consumer staples, and IT sectors, which are high growth and typically trade at higher valuations. Some ETFs, such as the iShares Indonesia ETF, have nearly half of their assets invested in banks. It is difficult for retail investors to replicate this industry breakdown while maintaining significant geographical diversification.

It is difficult to access some of these industries if you are limited to US exchanges. Most of the top ADRs, in countries like Indonesia and Colombia, are mainly banking and telecom stocks.

Geography

The main reason I do not solely invest in frontier and emerging market ETFs is because of the geographic exposure, not the industry weightings. Listed emerging market ETFs like this are highly diversified and efficiently track the benchmark index. However, the main downfall is that select salient emerging market investment themes represent less than 1% of these ETFs’ assets, which results in them having a limited impact on your portfolio performance.

Most emerging market funds are heavily concentrated in markets like China, Taiwan, and India. Nearly 72% of this fund’s assets are invested in China, India, Taiwan, and South Korea. This strongly excludes prominent regions like Latin America, MENA, and Africa. Moreover, there seems to be deeper value in smaller emerging markets with frontier characteristics.

Potential Modifications

Below are some of the modifications I have made by choosing to examine a basket of ETFs, closed-end funds, and ADRs in various emerging markets.

Less Exposure to the Top 3 Countries: A 30% weighting in China is extremely high for most investors, and not the best way to access emerging markets. As a retail investor, you have the relative advantage of being able to ignore benchmark indexes and bet on other under-the-radar markets.

Increasing South Korea Exposure: South Korea will likely outperform this decade, and I may keep 15-20% of my emerging market investments in South Korea. Korean equities have had a significant pullback after drastic outperformance in 2021. The MSCI Korea Index is currently trading slightly below book value and also trades at 9.7X PE.

Increasing Brazil Exposure: Equities in Brazil look very intriguing, as the market is currently trading at less than 6x PE. I have taken advantage of the 2022 sell-off to accumulate a lot of names in banking, energy, and other themes this year.

Emerging Asia: Thailand, Indonesia, Malaysia, and the Philippines are long-term bets, and it would not be unusual to allocate 10% of an emerging market portfolio to these countries. I am bullish on Indonesia and will take advantage of any dips during 2023.

Indonesia significantly outperformed emerging markets in 2022.

Mexico and South Africa: I am avoiding Mexico and South Africa for the time being. Within Latin America, I prefer other markets trading at a lower valuation, including Brazil, Chile, and Colombia (all of these markets trade at 5-6x earnings at the moment). Africa is difficult to access on US exchanges, and I am not as optimistic about the Van Eck Vectors Africa Index ETF (AFK). This ETF would be a better bet than investing in South Africa, as it also offers exposure to countries like Nigeria and Kenya.

The long-term underperformance of these markets is a combination of many factors, including political risks and external factors. However, rising commodity prices could be a catalyst for increased growth for some of these Latin American and African economies.

Underdogs: Many larger frontier and smaller emerging markets are not in this fund, or the fund invests less than 1.36% of its assets in these markets. I plan to make more concentrated bets (5-10% of total emerging market exposure) in some of these markets. Below are four markets I am closely following/investing in, with Egypt looking like the best bet. Turkey has also surprised many investors to the upside this year, yet this market is off the radar of most investors and is underrepresented in many emerging market funds.

ADR and Closed-End Fund Ideas

ADRs and closed-end funds are typically better bets within emerging markets. The only ETF I own at the moment is the Van Eck Vectors Egypt ETF (EGPT), simply because of the lack of other options. Below are other positions to consider as a part of an emerging market portfolio.

Brazil Alternatives: Brazil has nearly 30 ADRs that either trade on Nasdaq or the NYSE, so it really doesn’t make sense to trade ETFs. It is easy to build a basket of financial, consumer and energy stocks in this country. I covered one of Brazil’s largest meat exporters, BRF SA (BRFS), this summer. The stock is down over 40% after touching a bottom and looks like a solid buy now. Banco Bradesco (BBD) is also a solid play on Brazil’s economic turnaround and trades at a historical discount. Finally, Petrobras looks like an interesting speculative play, whether you are targeting dividend income or speculative outsized returns as the stock returns to levels previously seen during Lula’s last term.

South Korea: Investing in the Korea Fund (KF) may be the best option, as you can access the market at a discount. The discount for this fund has increased to 16% recently, which makes it an excellent buy.

Commodity Bets: I am also looking at key commodity-exporting emerging markets that can benefit from higher oil and copper prices. Banks in countries like Colombia, including Grupo Aval Acciones Y Valores (AVAL) and Chile are interesting buys at the moment.

Takeaway

I have a hold rating on the iShares MSCI Emerging Markets ETF because I believe there is deeper value in other overlooked places, and I think that emerging markets have a lot of challenges ahead of them. The iShares MSCI Emerging Markets ETF is an acceptable vehicle that will not have issues such as a tracking error or subpar performance due to poor management. However, it is a good idea to explore outside of this index and to make larger bets on smaller emerging markets. It is surprisingly easy to do this as a smaller retail investor.