The decision to invest in emerging markets can be quite daunting. Investors are first faced with deciphering the economic environment, and then with picking a “best fit” ETF for their objective.
To address the challenge of investing in emerging markets, you really need to break down the question into two parts; first, you need to consider an approach that can aid long-term investors in timing their EM ETF purchases. Second, investors should consider whether a currency-hedged strategy is right for their desired EM exposure.
When Should You Invest in Emerging Markets?
This is no easy question to answer because it’s inherently rooted in market timing. Nonetheless, there is historical research that could aid your decisions as to when you should buy and/or sell emerging-markets equities. According to research compiled by Credit Suisse, there are some noteworthy findings that will help answer the question, “When is the best time to buy emerging markets?”
Consider the image below which showcases how various rotation strategies have performed across developing markets for nearly four decades:
At first glance, the results are not at all intuitive. For instance, few would guess correctly that the countries with the lowest “past GDP growth” would end up grossly outperforming those with the highest growth. The currency factor is also worth highlighting; in the case of emerging markets, it appears that investing in the countries with the weakest currency has yielded far better returns that investing in those that boast the strongest local currency.
The ultimate takeaway is that the market tends to reward those who are capable of investing when uncertainty levels are high. In other words, it pays to be a contrarian investor in the case of emerging markets. Furthermore, some of the most compelling factors to consider when evaluating countries are the following:
- Dividend Yield: Higher yield has corresponded with stronger future returns.
- Currency Returns: Weaker local currency has corresponded with stronger future returns.
- Past GDP Growth: Dismal economic growth in the past has corresponded to stronger future returns.
For instance, it takes quite a bit of conviction to buy a country with negative GDP growth in lieu of one that is rapidly expanding; however, as the image above reveals, contrarian investors are often rewarded, and especially so over the long haul.
Currency Hedging in EM Stocks
There’s a host of factors to consider when deciding whether or not you should opt for a currency-hedged ETF in lieu of a traditional, unhedged one once you’ve already made the decision to invest overseas. Consider the following:
Expectations
Do you have a strong conviction that the U.S. dollar will appreciate over the next month? How about over the next year? If so, you should utilize a currency-hedged ETF because that way you can combine your currency expectations with your desired EM exposure.
Risk Tolerance
If you don’t even want to consider the implications of currency market fluctuations on EM stocks, then a currency-hedged ETF might be right for you. For conservative investors who are altogether hesitant to diversify into overseas equities, a currency-hedged approach is highly recommended so they can at least get their “feet wet.”
Time Horizon
For investors with a long horizon ahead of them, and the ability to stomach volatility along the way, the unhedged currency approach might be more ideal. The reason is simple: local currency returns are a major driver of total return in foreign markets, and over a very long-term period this can serve as a major tailwind.
Cost
If you’re a cost-conscious investor, then currency-hedged ETFs might not be right for you since they charge higher management fees than their unhedged counterparts.
Ways to Play
See this list of All Currency-Hedged ETFs.
You can also slice and dice the currency-hedged universe by region or country, if you like, using the ETF Database screener. Start here with a list of all currency-hedged ETFs.
Be sure to also check out the Currency-Hedged ETFs content center for all the latest analysis and education on the topic.
The Bottom Line
Take the time to consider whether you are making an allocation to emerging markets at an appropriate time, both relative to your own objectives as well as the global economic environment at hand. Once you’ve made the decision to diversify into overseas markets, be sure to consider currency-hedged equity ETFs because they might align better with your overall strategy.
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Image courtesy of sscreations at FreeDigitalPhotos.net
