Wednesday, August 06, 2008

Three Excellent Emerging Market ETF's

The other day, I posted about two popular emerging market ETF (EEM, VWO) choices. While you aren't likely to go too wrong adding one of these two major ETFs to your portfolio, I believe you can do better.

The three choices I examine here are all fundamental analysis ETFs, rather than based on old-fashioned market weighted capitalization like the prior two choices. What this means is the underlying stock choices are chosen on a rules-based entry system rather than how fat (or skinny) the valuations have gotten. I have written about fundamental analysis systems before, including here and here.

Wisdom Tree has used a dividend-rating system to select stocks most likely to outperform. This is based on back-testing that has shown that, firstly, dividend-paying stocks outperform their non-paying brethren, and secondly, that higher yields more often than not indicate relative undervaluation. Finally, Wisdom Tree's research shows that a basket of these stocks also have lower volatility than a comparable market-cap index.

The FTSE RAFI indexes, used in many Claymore and PowerShares products, uses four factors to weight stocks. These factors aren't related to the markets enthusiasm (or lack thereof) for the company itself, and extensive back-testing has shown these type of indexes outperform old-fashioned market cap indexes, such as the S&P 500, MSCI EAFE, and Dow Jones Industrial Averages. The factors are dividends, cash-flow, book value and sales.

The three choices we are looking at are Wisdom Tree and PowerShares products. They are the PowerShares FTSE RAFI Emerging Markets ETF (PXH), the WisdomTree Emerging Markets High-Yielding Equity ETF (DEM), and the WisdomTree Emerging Markets Small Cap Dividend ETF (DGS).

Let's take a look under the hood of these choices. Firstly, cost and turnover. On cost, none of them has a significant cost advantage, with DEM and DGS are 0.63%, and PXH at 0.85%. Turnover in PXH is 8% annually, with DEM at a remarkable 3% annual turnover. DGS does not have a reported turnover, but given that this is a small cap ETF, you can expect it to be relatively high, certainly higher than any of the choices I've discussed to date.

Let's look at the average company size and some of the top sectors in each product. In terms of average company size, these are all distinctly different products. DGS defines 92% of their portfolio as small cap, with the remainder as mid-cap. DEM is relatively agnostic for cap size, with 39% defined as large cap, 41% as mid-cap and 20% small cap. PXH, on the other hand, is primarily a large cap ETF, with 88% so defined, plus another 8% as mid-cap and a smattering of small cap.

In terms of the top four sectors, finance holds first or second place in all of them, and ranges from 26% in DEM to 19% in both DGS and PXH. Energy achieves one of the top four spots only in PXH, and there it holds first place with 26%. Information Technology holds down fourth spot in all the portfolios and range from 10-16%. Materials, at 14% is unique to DEM, while telecomm at 15% is unique to PXH. DGS has consumer discretionary in top spot at 19% (a unique top four holding) and industrials in third spot at 17% - again a unique top four holding.

Stock concentration is quite different among the three choices, with DGS holding around 400 stocks, and with the top four stocks holding 4.3% of the total portfolio value, and the top 20 companies accounting for 16% of the portfolio.

DEM holds around 300 stocks, with the top four stocks comprising 11% of the portfolio value, and the top 20, some 38%.

PXH is heavily concentrated by comparison to all of the choices reviewed so far: it holds around 160 stocks, the top four stocks account for a heavy 26% of the portfolio value while the top 20 stocks hold 60% of portfolio value. Essentially, this portfolio lives and dies with the top 20-30 stock choices.

Let's turn to country selection. In the Wisdom Tree ETFs, the top two countries represented in these ETF's are the same, with Taiwan holding top spot in both between 26-29%, and South Africa coming second at 11-15%. Brazil, Turkey, Malaysia, and Thailand fill out third and fourth spots at between 8-9% with the Asian choices in the DGS ETF.

The PXH ETF has China in top spot with 19%, South Korea with 18%, Brazil with 15% and Taiwan with 14%.

Finally, we turn to relative value measures of the portfolio. Dividends, as can be expected, rate high in the Wisdom Tree products, with recently reported yields of 7.92% (DEM) and 6.17% (DGS). The yield is not reported for PXH, but I'd say a reasonable guess, given portfolio size, and that consideration is given to firm size including dividends, would be in the 3-4% range.

PE ratios are attractive across the board, with DGS unexpectedly at the low of 9.3, DEM at 9.8 and PXH at 10.2. The price-to-book ratio varies from DGS, again at the low of 1.1, to 1.9 for DEM, and PXH at 2.7. Finally, the price-to-sales ratio is given only for DGS and DEM, at 0.71 and 1.21 respectively, which are both attractive, particularly the DGS.

Finally, let's look at the performance of these products year-to-date (note: DGS and PXH are less than one year old, hence the YTD comparison), compared to the iShares MSCI product EEM.

(Click to expand in size)

While PXH looks alot like EEM on the above chart, I believe that this is coincidental to some extent and the differences in the products will reveal themselves over time.

Looking at the products, DEM certainly appears to have low volatility, making it an easy choice for investors who prefer low volatility. Furthermore, the process for inclusion into the ETF also makes significant outperformance a reasonable possibility going forward.

DGS has relatively low volatility given its small cap orientation. I think of it as having just large cap volatility, but with the promise of small cap returns and a better selection process.

PXH is the large-cap ETF of the three. Offsetting to this usually comforting factor are the rather large bets on a relatively few number of firms, something you have to be comfortable with in order to be comfortable holding this ETF. On the other hand, the selection process is likely the most robust over the long haul for outperformance.

I lean slightly more toward the dividend approach in this instance, rather than other relative valuation measures, since other measures are more likely to be manipulated by accounting shenanigans, or simply poor disclosure practices. As the saying goes, "Dividends don't lie" ... and "Dividend investors sleep better". So for my money, I prefer the two Wisdom Tree products in this instance, although I have enormous belief that the PowerShares product will also prove itself over time.

In conclusion, I don't think the relatively low expense ratio of VWO is superior to the relatively low portfolio valuations offered by these three products and the superior selection process they employ, compared to both EEM and VWO. I believe the returns on all three of these products will outpace EEM and VWO over time.

Disclosure: Long positions in DEM, DGS.


The Confused Capitalist

1 comment:

stocksystm said...

Thanks for the informative article. I may add one of the Wisdomtree products to my conservative portfolio. The yields seem especially generous.