Want More Emerging Market Exposure With Less Risk? Check Out EEMV

Investing in more volatile markets can be daunting for many investors, especially when some of those markets are a bit more obscure than our good ole US equity markets. However, investing in some of those high risk, high return markets can potentially generate higher returns over long periods of time if you can stomach the ups and downs in the short-term. 

For investors that have a little less risk tolerance but still want exposure to emerging market equities – some of the most volatile markets – you can either reduce your exposure or invest in a strategy that attempts to reduce volatility.

We don’t necessarily favor one approach over another. If we have a positive view of emerging markets, we increase our exposure and shift more of our exposure into strategies that will fully participate in the direction of the market. On the other hand, if we have a less favorable view of emerging markets, we either reduce our overall exposure and/or increase the amount of our exposure to lower volatility strategies. 

One of the ETFs we use for the low volatility EM equity strategy is the iShares Edge Minimum Volatility Emerging Markets ETF (EEMV)

Fund overview & investment strategy

The iShares Edge Minimum Volatility Emerging Markets ETF tracks the investment results of the MSCI  Emerging Markets Minimum Volatility Index, which is composed of emerging market equities that have lower volatility characteristics relative to broader emerging equity markets. The fund manages over $5.5 billion in assets.

Emerging market equities remained under pressure over the last 12 months, as certain macro-economic developments such as a stronger dollar and trade tensions continued to hamper growth prospects of these countries. These developments were instrumental in pushing many retail and institutional investors away from emerging markets, but historically, emerging markets have provided significant returns in the long-run.

EEMV plummeted along with the broad market sell-off that triggered in September last year, but has recovered nicely over the last 3 months. EEMV has returned 22% to its investors over the last 5 years and has actually outperformed EEM since 2012.

(Source – ycharts)

EEMV uses an optimizer to select and weigh stocks from the MSCI Emerging Market Index in a way that minimizes the expected volatility of the portfolio. This investment strategy is expected to reduce the risk portion of the portfolio, and provide a meaningful downside risk protection to investors in turbulence times for emerging markets.

Sector asset allocation remains one of the primary focus areas of the fund, and historically, EEMV has allocated a higher percentage of the portfolio to traditionally stable sectors such as consumer staples and utilities. This falls in line with the core feature of the fund, which is to minimize volatility and improve risk-adjusted returns. On the other hand, the stock selection process involves a thorough study of correlation between individual stocks to ensure the risk profile of the fund remains at a pre-determined level.

Top sectors as of 31/12/2018

(Source – Factsheet)

The fund is currently exposed to the financials sector the most, which I believe is a strategic move considering the recent developments in the macro-economic space, which would be discussed in detail later in this analysis.

Understandably, the fund has a significant exposure to China, which doesn’t come as a surprise since China has been one of the greatest growth stories in the last couple of decades. However, EEMV has meaningful exposure to other emerging countries as well, especially to India, which is set to outpace China in the next half a decade.

Achieving an optimal level of diversification remains a key investment strategy of EEMV, as an optimal level of diversification helps mitigate risks while improving the return potential by having an exposure to emerging markets with dynamically different characteristics. 

Top countries as of 28/02/2019

(Source – iShares)

Current top holdings of the fund include a few telecommunication companies and many banks and financial services companies.

(Source – Factsheet) 

Portfolio construction strategy

As pointed out in the earlier segment, the investment objective of EEMV is to track the performance of MSCI Emerging Markets Minimum Volatility Index, which is referred to as the “underlying index” from now on. The underlying index uses a rules-based methodology to select securities with the lowest total risk from the MSCI Emerging Markets Index. In order to constitute the underlying index, MSCI looks for emerging market securities with the lowest absolute volatility using its multi-factor risk model.

However, in order to track the underlying index, EEMV uses representative sampling as a strategy to construct a portfolio of securities that is expected to represent the underlying index. As such, EEMV might or might not hold all the securities in the underlying index at any given point in time, but is expected to have similar characteristics, which is ensured by selecting appropriate weights, sectors, and securities to represent the underlying index. Due to the use of representative sampling, we can expect EEMV to report varying results from the underlying index momentarily, which needs to be factored in to the analysis by investors.

In the securities selection process of the underlying index, an emphasis is placed on identifying large-cap or mid-cap emerging market securities, which is reflected in EEMV as the fund tracks the performance of the underlying index.

Portfolio composition

(Source – Morningstar)

EEMV will at all times invest at least 90% of its assets in securities representing the underlying index, or securities that have very similar characteristics to that of the components in the underlying index. The remaining 10% can be invested in a range of securities including futures, options, swaps, cash, or even stocks that are not components of the underlying index, but all these investments should improve the ability of EEMV to track the underlying index while providing better risk-adjusted returns.

As the fund tracks the investment returns of the underlying index, which is the investment objective of the fund, EEMV is passively managed, and does not seek to generate alpha by taking defensive positions when markets seem overvalued. However, in order to earn additional returns, the fund at its own discretion might lend securities representing up to one third of the total value of the fund.

Valuation discussion

Emerging markets have provided significant returns to investors over many years, and this provides a compelling reason for investors to focus on investing in emerging markets for the long-run.

To gauge a measure of how emerging markets have performed in comparison with world markets, we can take a look at the performance graphs of MSCI World and MSCI Emerging Market Indexes.

(Source – MSCI)

Emerging markets have outperformed world markets over the last 15 years, despite a stellar performance from developed markets over the last couple of years. This provides a reason for investors to look for investment opportunities in emerging markets, while the varying levels of expected economic growth in certain regions provides another reason for investors to consider investing in high growing emerging markets.

Global GDP growth rate expectations

(Source – World Bank)

However, investing in emerging markets carries a significantly higher risk than investing in developed markets, as these regions have a high level of credit risk, and most of the time, political instability leads to massive losses in emerging equity markets.

Since its launch in 2011, EEMV has displayed a significantly lower volatility than the MSCI Emerging Market Index, which has provided investors with a certain degree of stability in their portfolios.

EEM vs EEMV comparison (last 3 years)

Standard DeviationBeta
MSCI  Minimum Volatility Emerging Markets10.98%0.58
MSCI Emerging Markets Index (EEM)14.83%0.82

(Source – MSCI)

EEMV currently yields over 2.3%, which is an attractive level of income return to investors. Even though the primary objective of investing in EEMV is to achieve capital appreciation, dividend distributions magnify the return of investors by providing a steady stream of income.

Annual distributions

(Source – Morningstar)

I believe the strategy to pick stocks in core sectors such as financials will pay off handsomely in the next several years. As internet penetration in emerging markets continue to rise, fin-tech concepts are likely to gain traction in these markets, and traditional banking and financial services firms are already gearing up for these changes by improving their infrastructure related to technological aspects.

The massive surge expected in fin-tech activities will drive the financials industry forward in emerging markets in the next several years, and this provides a meaningful opportunity for financial firms to earn higher economic profits in this period, which should be followed by higher stock prices.

Favorable demographics are certainly helping the financials industry in emerging markets. For example, 90% of people under 30 years reside in emerging countries, which provides a robust growth opportunity for financial firms to grow their earnings by introducing online banking and transaction facilities.

On the other hand, the dovish stance of the Fed is expected to help emerging markets in 2019 as well. Earlier in 2018, 4 rate hikes were expected by analysts in 2019, but as things stand today, we are more likely to see just 2 rate hikes in 2019. On the other hand, a set of analysts are predicting a rate cut in 2019. Even though assessing the accuracy of such predictions is not the core objective of this article, the outlook for emerging market performance is certainly better than what it was for 2018.

Furthermore, the trade war between the two largest economies in the world, the U.S. and China, continued to hurt emerging market performance in 2018, but the near future looks promising for international trade, as tensions are slowly but surely beginning to fade away, as the U.S. and China are nearing a trade deal. A trade deal will boost investor confidence, and will paint an optimistic outlook of emerging markets once again.

On the other hand, the U.S. dollar is expected to give away some of its recent gains later this year, as the prospects of further rate hikes through 2020 are expected to diminish. A weaker U.S. dollar will once again drive massive inflows to emerging markets, which should help these markets perform much better than most recent years.

Overall, growth prospects of emerging markets are promising, but investors still need to pay attention to mitigating inherent risks of investing in emerging markets. In this sense, EEMV becomes an attractive way to play emerging markets, as this ETF exposes investors to emerging market equities, but at a much lower risk than that of many other exchange traded funds.

Expenses

Annual expense ratio currently stands at 0.25%, which is significantly lower than many other peer emerging market ETFs. In fact, the category average is at 0.51% as per Morningstar data, which makes EEMV very attractive on a cost saving basis.

(Source – Prospectus)

Risks & challenges

If trade tensions escalate further, this will become a major obstacle for the growth of emerging countries. In this case, EEMV will fail to provide a meaningful return to investors, as equity markets in emerging countries will face a prolonged time period of meager gains.

A strong U.S. dollar will continue to remain a barrier for emerging market performance as well, and if U.S. economic growth accelerates better than expected, there is every possibility of additional Fed rate hikes, which should result in a stronger dollar in comparison to emerging market currencies. Another stream of outflows from emerging markets will surely lead to a sell-off in these markets.

Apart from these inherent risks of investing in emerging markets, investors face some unique risks of choosing EEMV to invest in these markets.

As EEMV is exposed to the financials sector of many emerging markets, an adverse development for this segment will result in lower than expected returns for investors. In particular, a change in regulations, or a slowdown in economic growth activities might hinder growth prospects of the financials sector.

As a passive index fund, EEMV faces the risk of not being able to track the benchmark fund accurately, which is known as the tracking error.

Conclusion

EEMV is an attractive ETF to play the expected growth in emerging markets over the next several years, and is suitable for even cautious investors who do not prefer the high-volatility of emerging markets. Many investors tend to pass emerging market investments as unsuitable, driven by the high volatility seen in these markets. EEMV provides an alternative way to invest in these markets, and focuses on stocks from core sectors, which are less volatile than sectors such as tech. EEMV has low fees, and has a history of providing attractive returns to investors, and is managed by a well-experienced portfolio management team. The dividend yields of 2.3%, combined with the attractive growth prospects of emerging markets provide a sound risk-adjusted investment opportunity for investors willing to go beyond boundaries. EEMV provides much needed diversification benefits as well, which is a core theme of investing in emerging markets.

Disclosure: I am/we are long BXP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: This article is meant to identify an idea for further research and analysis and should not be taken as a recommendation to invest. It does not provide individualized advice or recommendations for any specific reader. Also note that we may not cover all relevant risks related to the ideas presented in this article. Readers should conduct their own due diligence and carefully consider their own investment objectives, risk tolerance, time horizon, tax situation, liquidity needs, and concentration levels, or contact their advisor to determine if any ideas presented here are appropriate for their unique circumstances. Long: BXP, CIO, MNR, PLD, KIM, RPAI, SPG, TCO, STOR, O, IRT, APTS, AVB, UMH, AMH, AHT, PSA, SELF, GMRE, HCP, SBRA, PCH, AMT, CCI, SBAC, COR, QTS, IIPR, NLY, BXMT, NOBL, EEMV, EFL, JPS, LDP, HYLS, MORL, REM, RINF, SHY, SPY, TBB, TVC, EEM, HFQIX, FFRHX, DELNX, VOO, EFAV, EFA, SMMV, VO