The outperformance of stocks from emerging markets like China and India is getting harder to ignore. And it may not be over. The backdrop of a weaker U.S. dollar, plus faster economic growth overseas, is providing fuel to the rally.
The Vanguard FTSE Emerging Markets ETF (VWO) has jumped 29.6% over the past year versus a 22% rise in the Schwab U.S. Broad Market ETF (SCHB). VWO holds exposure to stocks from mega-sized markets such as Brazil, China, India and Russia, along with smaller markets like Mexico and Taiwan. With around $105 billion under management, VWO is the largest ETF by assets in its peer group.
LPL Financial anticipates faster growth from emerging markets to continue this year. The firm projects 5% to 5.5% real GDP growth from emerging markets compared to 4.5% to 5% for the U.S. and its developed-market peers.
“We expect emerging market economies to lead the global economic rebound in 2021,” said LPL Financial chief market strategist Ryan Detrick. “We believe growth in international developed economies may lag behind the United States, although a strong fiscal response may help Japan.”
The dynamic of higher inflation and a weaker U.S. dollar has provided another boost to emerging-market funds.
Besides receiving securities diversification, investors who own emerging-market ETFs also get currency diversification. Here’s how: The securities held inside ETFs are denominated in their local currencies. As a result, ETF returns can be further lifted if the value of the dollar is weak relative to global currencies.
Despite the bullish trend, the leadership in emerging-market stocks has been limited to Africa and Asia. The VanEck Vectors Africa Index ETF (AFK) has gained 6.9% year to date while the Vanguard FTSE Pacific ETF (VPL) has gained 5.4%. Meanwhile, the iShares Latin America 40 ETF (ILF) has experienced a 4.2% decline during that time frame.
In the leveraged ETF market, the Direxion Daily Emerging Markets Bull 3x Shares (EDC) and the Direxion Daily FTSE China Bull 3x Shares (YINN) have soared 24.8% and 35.4% year to date, respectively. Both funds use 300%, or 3x daily leverage to magnify their returns.
Although the arguments for using actively managed funds over index funds in emerging markets are many, the data still supports the wisdom of an index-focused strategy.
In a 15-year study from 2005 to 2020, the SPIVA scorecard from S&P Dow Jones Indices found a whopping 84.2% of actively managed emerging-market funds underperformed their index counterparts. Although there will always be some active funds that beat the indexes, the odds of successfully identifying them in advance are slim.
The lower cost of ETFs is another bonus. Index-linked emerging-market ETFs offer an affordable choice for financial advisors who want to keep a lid on the fees charged to their clients by fund companies. For example, the average expense ratio for emerging-market funds is a bloated 1.31% compared to just 0.10% for VWO. That translates into sizable cost savings of $2,689 on a $10,000 investment over the next 10 years.
Investing great John Bogle once quipped: “While an index-driven strategy may not be the best investment strategy ever devised, the number of investment strategies that are worse is infinite.”
Looking ahead, there’s a lot to like about the bullish price action of emerging markets. Besides an indirect hedge against a weak dollar, it could give your clients a much needed boost if U.S. stocks start to lag.
Ron DeLegge is founder and chief portfolio strategist at ETFguide, and is the author of “Habits Of The Investing Greats.”