VWO Vanguard FTSE Emerging Markets

Emerging market investments, once a favorite investing destination, has mostly seen a pathetic 2013 thanks to the taper talk by the Federal Reserve. The fears deepened again when the Fed finally decided on a modest tapering (worth $10 billion per month) starting in January 2014.

Domestic capacity constraints, falling currencies, higher inflation, and the expected cease of cheap dollar on the ‘QE Taper’ weighed on emerging markets this year. Most of the emerging markets funds closed out 2013 in the red with top ETFs like Vanguard FTSE Emerging Markets ETF (VWO), iShares MSCI Emerging Markets Index Fund (EEM), WisdomTree Emerging Markets High-Yielding Equity Fund (DEM) shedding more-or-less 10%.

If these were not enough, Goldman Sachs’ (GS) warning on emerging market investing was another nail in the coffin. In a recent report, the bank forecasted "the strong possibility of significant underperformance and heightened volatility over the next five to 10 years”.

This investment banking firm also suggested investors with ‘moderate’ risk tolerance to cut down their emerging market holdings by one-third i.e.; from 9% to 6% of the overall portfolio (read: 2 Worst Performing Emerging Markets ETFs This Year).

Behind Goldman’s Skepticism

In its 59-page report, Goldman argued that emerging market outperformance from 2003 to 2007 was due to some specific economic tailwinds which are unlikely to resurface. Rather than holding the Fed taper talk solely responsible for the recent underperformance, Goldman pointed to the structural problems in those nations.

As per Goldman, the downside in investors’ perception about emerging markets has been noticed due to high volatility as well as the lower-than-expected growth rate and the subsequent returns.

“The over-involvement of governments in their economies, increasing reliance on commodities and unfavorable demographic trends” of some big nations are crippling growth (read: Emerging Markets = Imploding Markets?).

This global investment bank now expects only "low single-digit" returns out of emerging market debt in 2014 with profits and losses around 10%. The banking giant predicts "high single-digit" returns for stocks, with gains or losses of approximately 20%.

Our Take

Though worries are definitely building up on emerging markets in next year’s taper-stricken environment, investors should note that the emerging markets have already taken much of the taper shock in stride. In fact, broader emerging funds like EEM, VWO and DEM have gained, though marginally, in the last five days following the announcement of modest tapering.

In such a situation, investors should be extra careful before investing in those countries. While picking nations, the only criterion should be better inherent strength rather than too much of a dependence on foreign capital (read: 3 Emerging Markets ETFs in Focus on Improved Data).

Secondly, though the Fed will scale back the QE program, the bulk of the stimulus ($75 billion a month) still remains in place. The Fed Chairman, Ben Bernanke commented that the bond buying program will be curtailed in phases in 2014 if improvement in the labor market is in accordance with their expectation and might be completed by late 2014 (read: Fed Tapers Bond Purchases: 3 ETFs in Focus on the News).

Thus, we believe that there is still time before one gets too bearish on emerging nations. Investors having a strong stomach for risks might consider buying some selective emerging market products.

We have highlighted three options below. The trio has a great Zacks ETF Rank of ‘2’ (Buy) and could be interesting picks at least for the near term.

Vanguard FTSE Emerging Markets ETF (VWO) in Focus

This ETF is the most popular and the largest fund in the emerging market space and manages a huge asset base of $46.0 billion. With annual fees of 18 basis points it is also one of the cheapest within its category. China and Taiwan comprise about one-fourth of the total holdings.

The product holds a basket of 922 stocks, with the concentration level in the top 10 holdings at 16.7%. VWO has shot up 10.23% in the past 6-month period.

Core MSCI Emerging Markets ETF (IEMG) in Focus

IEMG looks to track the MSCI Emerging Markets Investable Market Index which is a capitalization-weighted index. In its 1,750-stock portfolio, the top 10 holdings account for 14.6% thus calling for low concentration risks. So far, the fund has generated AUM of $3.2 billion. China, South Korea and Taiwan account for around 45% of the total assets.

The ETF also charges only 18 bps in fees a year. The fund lost 6.3% in YTD frame (as of December 24) while it gained 10.7% in the last 6-month period.

S&P Emerging Markets Low Volatility Portfolio (EELV) in Focus

This ETF – tracking the S&P BMI Emerging Markets Low Volatility Index – invests about $222.5 million of assets in 202 securities from emerging markets. The Index comprises the 200 least volatile stocks of the S&P Emerging BMI Plus LargeMid Cap Index over the past 12 months.

Taiwan takes up the top spot with 26.73% of exposure while the top 10 holdings make up about 10% of the fund. Notably, Taiwan is a relatively well-placed nation in the emerging markets pack.

Two Taiwan-focusedfunds iShares MSCI Taiwan Index Fund (EWT) and First Trust Taiwan AlphaDEX Fund (FTW) delivered positive returns in 2013. The fund added 6.09% in the past 6 months. EELV is also a cheaper fund, charging 0.29% a year in expenses.

Bottom Line

Emerging markets may face significant issues in 2014, but investors should note that stock markets in developed countries hovering at lofty levels leaves little room for material upside. What remains undervalued now are the emerging markets.

Yes, concerns over China are looming large with a web of credit issues. Brazil has problems of slower growth and heightened inflation. Thailand, though having better fundamentals, is grappling with political disruptions.

Also, in 2014, we are most likely to see a stronger dollar against a basket of major currencies leading to huge capital outflows which in turn will pose another round of threats to the current account deficit balance of nations like Indonesia and India (read: Surprise Rate Hike Puts Indonesia ETFs in Focus).

That said, we suggest investors consider some export-oriented emerging nations which will grow from higher export demand from developed nations as well as safeguard themselves from depreciating currencies. These might be the picks to look at this year, and could outperform their counterparts in this rocky space over the next 12 months.

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WISDMTR-EM EQ I (DEM): ETF Research Reports
 
PWRSH-SP EM LVP (EELV): ETF Research Reports
 
ISHARS-EMG MKT (EEM): ETF Research Reports
 
ISHARS-CR MS EM (IEMG): ETF Research Reports
 
VANGD-FTSE EM (VWO): ETF Research Reports
 
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