For most of the last few years, investors have largely ignored emerging market stocks as the prolonged and positive momentum of the U.S. economy and healthy corporate earnings reports kept them satisfied with stocks closer to home.

Over the five years ended August 31, the annualized return for the MSCI Emerging Markets Index was 5.3%, while the S&P 500 returned 14.4%.

While both markets have moved up this year, emerging markets have taken the lead by a wide margin as investors reward reports of the stronger corporate earnings that began in late 2016 and continued into 2017. As of August 31, Vanguard’s FTSE Emerging Markets ETF (VWO) was up 25% year to date, over twice that of the S&P 500. China staged an especially impressive rebound, with the iShares MSCI China ETF (MCHI) up 42% during the first eight months of the year.

It’s unclear whether the emerging markets upswing is a sign of its short-term frothiness or a longer-term switch in its performance leadership. When you compare them with those in other parts of the world, the stocks aren’t particularly expensive. The MSCI Emerging Markets Index sported a 12.5 forward price/earnings ratio as of August 31, while U.S. stocks’ P/E ratio was 17.8, according to Yardeni.com. The valuations are also more reasonable than those of stocks in Japan and Europe, though the gap is less dramatic than it is with U.S. stocks.

The emerging markets discount relative to the U.S. hasn’t been this wide since 2005, noted a recent report from ETF provider WisdomTree. Beginning that year, the MSCI Emerging Markets Index began a three-year stretch of returning at least 32% annually—significantly higher than the 28.2% cumulative return for the S&P 500 over the same period. Over the last 20 years, the valuation gap between the MSCI EM Index and the S&P 500 has rarely been as large as it is now. Whenever it was, returns for the former index significantly exceeded those for the latter over the next five years.

Emerging market fund managers say that superior economic and corporate earnings growth in these countries could support further momentum. Mark Mobius, the executive chairman of the Templeton Emerging Markets Group, opined in an August report, “While areas of risk remain, our view is that we are still in the early innings of the emerging market earnings growth upturn. We also believe valuations and sentiment continue to be supportive.” Nonetheless, he warned that unpredictable U.S. trade policies, rising political tensions, and the potential for interest rate hikes in the U.S. “could dampen sentiment and lead to market volatility.”

Also in August, mutual fund and ETF giant BlackRock recommended an overweight position in emerging market equities, noting the help they are getting from a synchronized global recovery and dollar weakness. Also, the fund manager is less concerned, at least for the time being, about tighter credit conditions in China, which would lead to a broad deceleration. The fading fears about China has helped improve investor sentiment, says BlackRock. The firm especially favors China, where an uptick in corporate profits is helping wean the country’s companies from dependence on external credit. India, which is undergoing tax and governance reforms that should ultimately prove fruitful, also looks attractive to the firm.

Active, Passive or Smart Beta?

Those considering beefing up or tweaking emerging market allocations can choose from actively managed mutual funds, index ETFs or the newer breed of factor ETFs. Fund managers covering these countries say they are fertile ground for active managers, since investors can take advantage of less efficient markets, buy under-the-radar stocks and make decisive country allocations that differ from widely used benchmarks. The managers note that many market-cap-weighted indexes, by contrast, have a hefty presence in lumbering, poorly managed state-owned enterprises, have more money allocated to China than many actively managed funds and overemphasize slow-growth sectors such as utilities and telecommunications. They also give short shrift to small-cap stocks. If investors are going to use active management for at least some investments, proponents of the practice say this is where it could make a real difference.

But the evidence is mixed that active EM funds beat passive. Certainly Morningstar’s Active/Passive Barometer, which compares active managers against a composite of passive ETFs, presents a generally positive view of active management, at least in this space. Over the five years ending June 30, 2017, only 20.4% of actively managed U.S. large blend funds outperformed their passive peers. But in the emerging market space, roughly 70% of actively managed diversified emerging market funds did so. Over the three-year period, 19% of the U.S. funds outperformed, while 67% of the emerging markets group did.

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