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EM ETFs: What You Need to Know Before Investing

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Emerging market (EM) ETFs have had a great run this year (as of August 7, 2017) with iShares MSCI Emerging Markets ETF (EEM - Free Report) returning over 26%. The segment is doing well on improving global economic fundamentals and moderately accommodative developed market central banks that are still keeping interest rates low and driving investors toward the relatively high-yielding EM bloc.

A late July report issued by EPFR Global indicated that investors poured money into EM funds for 19 weeks in row. If the momentum continues for over a month, it can tie its 24-week stretch of inflows from first-quarter 2013. From last December, an average of $24.4 billion inflows made into emerging-markets stocks and bonds each month, according to data from the Institute for International Finance.

Against this backdrop, many may question if investors’ animal spirits will remain in the months ahead. So, what are the factors that investors need to consider before investing in EM ETFs? Let’s find out.

Fed Fear Probably Exaggerated

EMs are believed to perform in a rising rate environment in the U.S. But the theory seems to be losing its worthiness in recent trades. Though the Fed has enacted two rate hikes this year, the benchmark U.S. Treasury yields are broadly at lower levels. Plus, the U.S. central bank is unlikely to be aggressive on policy tightening in the coming days on account of still-subdued inflation. So, the Fed fear should not be that heightened in the coming days when it comes to EM investing.

In any case, as per Deutsche Bank, the correlation between EM performance and the benchmark U.S. Treasury yields since 2010 has been positive except for 2013, when taper talks weighed heavily on emerging market securities. In 2013, the correlation between EM equities and the U.S. 10-year yield was negative 69%. But if we strike out that period, the correlation turns out to be positive 74% (read: What Can Make EM ETFs a Winner in 2017?).

China’s Dubious Role in EM Investing 

The Chinese economy – the largest emerging market – has been gaining momentum lately. iShares China Large-Cap ETF (FXI - Free Report) is up about 24% so far this year (as of August 7, 2017). But the economy is still guilty of a slowdown. The year 2016 saw China's slowest growth clip in 26 years.

Factory output has long been a cause of concern for the Chinese economy. Bank lending ballooned despite repetitive caution relating to the country's ominously high corporate debt level. Economists flagged caution as high leverage and inflated property valuation may put a check on its growth.

EPFR Global data indicated that China exhibited 10 successive weeks of outflows in late July. In fact, for investors believing in the emerging market rebound but looking to have a China-free exposure, iShares MSCI Emerging Markets ex China ETF EMXC and Columbia EM Core ex-China ETF XCEM can be good options.

Stretched Valuation?

After such a steep ascent, there is a chance that the rally may not sustain. The P/E (ttm) of EEM is 12.32 times for EEM and 17.79 times for SPDR S&P 500 ETF (SPY - Free Report) . But there are certain EM ETFs that have higher P/E (ttm) than SPY. Higher growth prospects are definitely baked in the current valuation.

India ETF iShares India 50 ETF (INDY - Free Report) has a P/E of 21.07 times, iShares MSCI Philippines ETF (EPHE - Free Report) has a P/E of 20.11 times,PowerShares DWA Emerging Markets Momentum Portfolio ETF (PIE - Free Report) has a P/E of19.74 times, iShares MSCI Indonesia ETF (EIDO - Free Report) has a P/E of 19.33 times and Vanguard FTSE Emerging Markets ETF (VWO - Free Report) has a P/E of 18.50.

In fact, GEM Equity Fund managers reduced their positions in India, with the average GEM Fund allocation at its lowest level since early 2Q15. So, at this stage, valuation is a key thing to consider and it is better to grab low P/E funds. As per an article published on Wall Street Journal, “stocks in emerging markets right now are trading at big discounts when compared with the shares of similar U.S. companies” (read: India to Unify Tax: Near-Term Pain/Long-Term Gain for ETFs).

Optimistic IMF’s Projection: Dollar to Remain Weak?

The International Monetary Fund (IMF) is optimistic about the economic outlook for emerging markets while it is less positive about the U.S. economy. The agency beefed up the growth estimate for emerging markets and developing economies to 4.6% this year from last year's 4.3% forecast. At the same time, U.S. growth projections were revised down to 2.1% for 12017.

It means weaker U.S. economic growth is likely to keep the greenback subdued. In any case, the dollar index has fallen for five successive months, registering the longest losing streak since April 2011. Notably, commodities are likely to gain in a subdued dollar environment. This should bolster the commodity-rich EM ETFs (read: If Dollar Remains Weak, Bet on These ETFs & Stocks).

Fading Trump Bump

Political uncertainty related to Trump’s proposed policies and lack of fiscal boost so far in the Trump administration has kept the dollar low. Plus, worries over trade issues with Mexico, ban on outsourcing or trade barriers with China have also been ebbing. This should bode well for EM investing (read: Emerging Market ETFs Dip after Trump Win, Time to Buy?).

EM Looks Less Perturbed by Brexit

Though Brexit fears have taken a backseat lately on overall global investing, investors should specifically note that trade relations between the U.K. and the broad-based emerging market are meager, thus posing no-to-little threat to emerging market investing (read: Bremain or Brexit: No Worries for EM ETF Investing).

Low Interest Rates Worldwide = Hunt for Yields

Globally interest rates are at low levels, especially in the developed world. Several central banks including the Euro zone and Japan are practicing negative interest rates in order to shore up growth and mitigate deflationary threats.

All in all, such low interest rates worldwide would push global investors toward EM ETFs (for higher yield) this time, unlike what we saw amid the taper tantrum in 2013, when the benchmark U.S. Treasury yield crossed the 3% mark.

EM ETFs to Play

EM Bond ETFs

These are meant for higher yields and lesser risk than equities. PowerShares Emerging Markets Sovereign Debt Portfolio ETF (PCY - Free Report) (yields 4.95%), Vanguard Emerging Markets Government Bond ETF VWOB (yields 4.93%) and VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (EMLC - Free Report) (yields 5.07%) are some of the good choices.

EM Dividend ETFs

Dividend-focused ETFs also offer some cushion against price volatility. WisdomTree Emerging Markets High Dividend Fund (DEM - Free Report) (yields 3.50%), SPDR S&P Emerging Markets Dividend ETF (EDIV - Free Report) (yields 3.92%) and MSCI Emerging Markets Dividend Growers ETF EMDV (yields 2.24%) can be considered.

Low Volatility ETFs

There are low volatility ETFs like Legg Mason Emerging Markets Low Volatility High Dividend ETF LVHE. Notably, funds like iShares Currency Hedged MSCI EM Minimum Volatility ETF HEMV and WisdomTree Strong Dollar Emerging Markets Equity Fund EMSD can be tapped if the greenback suddenly gains strength.

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