Emerging & Frontier Markets ETFdb Portfolio

Published on by on September 23, 2010 | Updated February 11, 2014

Portfolio Strategy

The Emerging & Frontier Markets ETFdb Portfolio is designed for investors looking to overweight the world’s developing economies and underweight advanced markets. In the current economic environment, the growth gap between developed and developing markets has widened considerably, while the risk gap has narrowed. Although many investors retain the perception that emerging markets are excessively risky, the developing world has become an increasingly critical component of any portfolio seeking to deliver capital appreciation over the long term. Although incomes in emerging markets may be low compared to the developed world, these economies often have rock solid balance sheets, diverse economies driven by manufacturing or natural resources, and growing populations. These trends look likely to continue and could give a large boost to investors willing to wait for these markets to mature. Despite these positives, many of these countries remain very far behind developed market standards in a variety of categories including health, infrastructure, and political stability.

This ETFdb Portfolio was constructed without significant exposure to developed market equities or bonds. Filling the position occupied by U.S. and EAFE securities in traditional portfolios are emerging market assets. Sliding up to fill the smaller allocation traditionally afforded to emerging markets are frontier markets–those on the third of the three development tiers. This ETFdb Portfolio is heavy in large cap emerging market funds but it also has a large slice of its total assets in real estate (5%), and currency funds (10%). This portfolio also offers 30% exposure to emerging market bonds, which tend to pay out higher yields than comparable securities from issuers in developed markets. This portfolio may be excessively risky for retired investors, but could make for a good option for investors with a long time horizon and a high risk tolerance.

  • Risk Tolerance: High. Emerging markets are often extremely volatile and subject to a variety of risks including political factors, government interventions, and economic instability. Due to this, investors must be ready to accept significant swings in value in a short period of time in order to invest in this portfolio.
  • Time Horizon: Intermediate to Long. This ETFdb Portfolio maintains a bright long-term outlook, but may be subject to significant short-term swings. Investors retiring soon or those that may need the cash in the immediate future would be wise to stay away from this fund.
  • Current Income Needs: Low. This ETFdb Portfolio maintains significant equity exposure, including big allocations to funds that do not make significant dividend payments. However, emerging market bonds often pay higher yields than their domestic counterparts allowing investors to boost their income despite extremely low bond yields in the developed world.

Portfolio Snapshot

Ticker Fund Asset Class Allocation Expense Ratio Alternative ETFs
VWO Vanguard Emerging Markets ETF International Equities 25% 0.20% EEM
EWX SPDR S&P Emerging Markets Small Cap ETF International Equities 15% 0.65% DGS
FRN Claymore/BNY Mellon Frontier Markets ETF International Equities 15% 0.65% PMNA
ELD Emerging Markets Local Debt Fund Fixed Income 15% 0.55% EMLC
PCY PowerShares Emerging Markets Sovereign Debt Portfolio Fixed Income 15% 0.50% EMB
CEW WisdomTree Dreyfus Emerging Currency Fund Currency 10% 0.55% BZF
TAO Claymore/Alphashares China Real Estate ETF Real Estate 5% 0.65% RWX
Weighted Average Expense Ratio 0.49%

Historical Return Analysis

Ticker 2009 2010 2011 2012 2013
VWO 75.3% 19.5% -18.7% 19.2% -4.92%
EWX 94.7% 23.5% -30.2% 26.6% 1.95%
FRN 54.3% 33.9% -22.4% 12.3% -14.6%
ELD n/a n/a -2.2% 14.4% -10.7%
PCY 36.0% 10.8% 8.4% 20.8% -10.2%
CEW n/a 6.4% -8.0% 7.1% -4.87%
TAO 72.9% 10.7% -25.6% 58.8% -9.34%
Portfolio n/a n/a -13.7% 19.6% -7.2%
Compare to SPY 26.3% 15.0% 1.2% 16.0% 32.3%
Compare to AGG 3.3% 6.4% 7.7% 3.8% -2.0%

The adjacent table provides historical results for each component of this ETFdb Portfolio, as well as backtested results (as available) for the entire portfolio from 2008 to 2012. The table also shows how this ETFdb Portfolio performed relative to a popular stock market benchmark (SPY) and bond benchmark (AGG).

Not surprisingly, this ETFdb Portfolio struggled in 2008 and in 2011 amidst a broad market recession. In 2009, 2010, and 2012 this ETFdb Portfolio reclaimed much of the ground lost during 2008 and again in 2011.

Many of the emerging market equity ETFs in this ETFdb Portfolio have posted tremendous gains over 2009, 2010, and 2012 as fears over the global equity market subsided and allowed many investors to embrace risk again. In fact, nearly every equity ETF in this portfolio was able to outperform the broad stock market in the years of recovery following the recent financial crisis.

Portfolio Expenses

This ETFdb Portfolio is designed for long-term use consistent with a “buy, hold, and rebalance” strategy. As such, minimization of expenses is necessary to avoid return erosion resulting from compounding costs. To this end, we constructed a portfolio with a weighted-average expense ratio of 46 basis points, which is significantly lower than fees charged by actively-managed mutual funds. The impact of this reduced costs structure over the horizon of this portfolio is significant:

    Growth of $1 Million Over 30 Years @ Annual Return Of:
Portfolio Expense Ratio 5% 10% 15%
Emerging Markets ETFdb Portfolio 0.49% $3,756,085 $15,262,067 $58,250,873
Actively-Managed Mutual Fund Portfolio 1.00% $3,243,398 $13,267,678 $50,950,159

Holdings Overview

Below is a brief overview of each component of this ETFdb Portfolio:

  • VWO: This ETF measures the performance of the emerging market stocks with a focus on large cap companies.
  • EWX: This ETF tracks an index that is a float adjusted market cap weighted index that represents the small capitalization segment of emerging countries included in the S&P Global BMI Index.
  • FRN: This ETF follows the performance of depositary receipts, in ADR or GDR form, that trade on the London Stock Exchange, New York Stock Exchange, NYSE Amex and Nasdaq Stock Market of companies from countries that are defined as Frontier Markets.
  • ELD: This actively-managed ETF invests in debt from emerging markets issuers. ELD invests exclusively in debt denominated in the local currency, potentially adding diversification benefits and allowing investors to benefit from a rise in emerging markets currencies relative to the U.S. dollar.
  • PCY: This ETF tracks the potential returns of a theoretical portfolio of liquid emerging markets U.S. dollar-denominated government bonds issued by approximately 22 emerging-market countries
  • CEW: This ETF seeks to deliver returns reflective of both money market rates available in emerging markets and changes in the value of a basked of EM currencies relative to the U.S. dollar.
  • TAO: This ETF follows a benchmark that is designed to measure and monitor the performance of the investable universe of publicly-traded companies and REITs deriving a majority of their revenues from real estate development, management and/or ownership of property in China or the Special Administrative Regions of China, such as Hong Kong and Macau.

Portfolio Risk Analysis

This ETFdb Portfolio has a heavy tilt towards risky assets, although it also  gives significant weightings to fixed income securities. In addition to its 55% weighting to equities, the fund offers a 10% allocation to emerging currencies and a 5% allocation to Chinese real estate. The fund makes up for its higher risk level in equities with a lower weighting to the these securities than comparable high risk portfolios.

The emerging markets equity allocations can generally all be considered risky investments. Yet, within this classification there are varying degrees of risk. Many of the large cap tracking ETFs can probably be considered no more risky than some developed markets while small and medium cap securities in these countries are generally fraught with risks. Even further towards the risky end of the spectrum are frontier market countries–among the riskiest equity investments that an investor can make in the non-leveraged ETF world. We have limited the exposure to real estate in this ETFdb Portfolio to 5% to minimize the loss potential from this asset class while still maintaining potential for outperformance. Unfortunately, the only current option for investors seeking emerging market real estate exposure is to invest in TAO; this could change in the near future and investors could consider a more broad based international real estate ETF in order to help smooth overall portfolio volatility and provide better diversification benefits.

Equity Overview

This ETFdb Portfolio contains an allocation of 55% to equities, all of which are in international, emerging and frontier markets. The vast majority of this portfolio’s equity holdings are in large and giant cap stocks, which generally have a market capitalization of more than $10 billion.

Large cap equities tend to be more stable than mid cap stocks, but also typically offer less growth potential. Although correlation between equities of different sizes is strong, the inclusion of small and micro cap equities in this portfolio does offer some diversification benefits, and also offers exposure to companies more likely to experience significant growth. Frontier markets tend to be even less correlated with major equity markets and can also provide diversification benefits, however these securities tend to be extremely risky due to their illiquid markets and often unstable political climates.

The equity portion of this ETFdb Portfolio is dominated by stocks listed and operating primarily in the BRIC nations of Brazil, Russia, India, and China. Beyond this first tier, most emerging market funds offer significant levels of exposure to South Korea, Taiwan, and South Africa.

VWO [Fact Sheet]

One of the most popular emerging market ETFs, VWO offers exposure to the MSCI Emerging Markets Index, which is designed to measure the performance of emerging market equities. VWO is heavily weighted in large and giant cap firms which make up a large majority of the fund’s total assets. In terms of individual securities, the fund is extremely spread out holding over 800 different equities and just a tenth of its assets going to its top ten holdings. With an expense ratio of just 20 basis points, VWO is one of the cheapest ETFs in the Emerging Markets ETFdb Category, coming in at less than half of the category average.

EWX [Fact Sheet]

While the majority of the equity exposure in this ETFdb Portfolio is achieved through large cap equities, including small and mid cap funds can provide valuable return enhancement and diversification benefits. EWX invests exclusively in the small capitalization segment of emerging countries included in the S&P Global BMI Index. The fund is heavily weighted towards Taiwan and China, with large weightings also going towards India, South Africa, and Brazil. Its top sectors include technology, consumer goods, and industrials while maintaining a minimal allocation towards capital intensive industries such as energy and utilities.

FRN [Fact Sheet]

FRN offers investors exposure to what is known as the ‘Frontier Markets’ or countries which are one step below emerging markets. Generally, these markets are in Latin America, Africa, and the Middle East and are inaccessible to investors in other funds. As such, they can often provide potential for big returns but also increased volatility. That makes them a potentially valuable diversification agent and a critical component of any portfolio focused on emerging markets.

Fixed Income Overview

Despite the diversification across sizes and geographies within the equity component of this ETFdb Portfolio, many of these funds maintain relatively high correlations with each other (as evidenced below). In order to smooth overall volatility and achieve stable returns, we have allocated a third of this ETFdb Portfolio to two fixed income funds: ELD and PCY.

ELD [Fact Sheet]

This ETFdb Portfolio achieves half of its fixed income exposure through ELD, which offers exposure to debt from emerging markets issuers denominated in the local currency. Because the underlying holdings of ELD are denominated in local currencies (and not the dollar), this fund also offers some diversification away from the greenback. The majority of ELD’s holdings are rated A or higher, and the fund offers exposure to more than a dozen different countries.

PCY [Fact Sheet]

The other main component of this portfolio’s fixed income exposure comes from PCY which focuses in on liquid emerging markets U.S. dollar-denominated government bonds issued by approximately 22 emerging-market countries. Unlike ELD, the holdings of PCY are denominated in U.S. dollars. The fund offers investors a higher coupon rate but also a lower credit quality level, suggesting that PCY may be more volatile than EMB. This PowerShares fund does charge a relatively low expense ratio–coming in at just 50 basis points–and pays relatively handsome yield.

Real Estate Overview

While many investors now avoid exposure to real estate (besides direct exposure through their residence), we believe this asset class can still offer valuable diversification benefits, as well as opportunities for enhanced returns in certain environments. This can be especially true in dynamic emerging markets such as China where rising incomes are likely to increase demand for high-quality real estate properties both in the residential and commercial sectors.

TAO [Fact Sheet]

In order to boost current income while simultaneously allowing for robust future gains, we have allocated a small portion of this ETFdb Portfolio to TAO, which invests in REITs and publicly traded companies deriving a majority of their revenues from real estate in China or the special administrative regions of China such as Hong Kong or Macau. The fund holds less than 50 securities, a third of which are from Hong Kong. TAO does charge an expense ratio of 0.65%, among the highest in the Global Real Estate ETFdb Category.

Currency Overview

While we generally tend to avoid currency ETFs in our ETFdb Portfolios, we believe that a case can be made for an investment in emerging market currencies. Emerging market countries tend to pay out higher money market rates than their developed counterparts and they also have seen currencies appreciate rapidly against much of the developed world over the past few years thanks to their vast current account surpluses. Because the currency ETFs highlighted below offer exposure to money market-like rates, we believe it is perhaps more appropriate to thing of these allocations as short-term fixed income securities that offer potential for appreciation against the U.S. dollar.

CEW [Fact Sheet]

We felt that an allocation to CEW would be appropriate in this portfolio for two reasons. First, the fund offers investors exposure to rapidly appreciating currencies which have grown more in demand as emerging markets make up a bigger piece of world trade. Second, this can be thought of as a short-term bond compliment for investors seeking exposure to emerging markets, since it generally invests in liquid short-term contracts helping to compliment the rest of this Emerging & Frontier Market ETFdb Portfolio.

ETF Correlation Matrix




Diversification is a key component of any client portfolio. The adjacent chart shows the correlation between each component of the Emerging & Frontier Markets ETFdb Portfolio over the last two years.

As is expected, there is a fairly strong correlation between the equity components in this ETFdb Portfolio. The fixed income elements of this ETFdb Portfolio add meaningful diversification benefits to the portfolio. Overall, this portfolio maintains a moderate degree of diversification resulting from the significant allocation to fixed income securities.

Disclaimer

The information herein is not represented or warranted to be accurate, correct, complete, or timely. Past performance is no guarantee of future results. All investors should read applicable prospectuses before investing.

From time to time, the authors of this report or other employees of ETF Database may have a long or short position in securities referred to herein. The factual statements herein have been taken from sources we believe to be reliable, but such statements are made without any representation as to the accuracy or completeness or otherwise.