ETFs providing exposure to emerging market (EM) equities may offer a buying opportunity for value-seeking investors following the asset class’s sell-off earlier in the year, according to BMO Global Asset Management.

Morgane Delledonne, ETF Investment Strategist at BMO Global Asset Management

Funds tracking the EM space have taken a knock in 2018.

The MSCI Emerging Market Index – arguably the most popular EM index within the ETF industry and the underlying reference for funds including the $5.0bn iShares MSCI EM UCITS ETF (IEEM LN) – has lost 10.5% year-to-date and is down 18.5% since its peak at the end of January.

According to BMO GAM, the flight from EM reflected a shift towards risk-off sentiment which was triggered by rising interest rates in the US combined with the escalation in trade tensions. EM currencies have been under pressure despite central banks’ interventions.

While EM equity ETFs are clearly being affected by these headwinds, BMO GAM believes the pullback experienced thus far this year may be overdone.

Morgane Delledonne, ETF Investment Strategist at BMO Global Asset Management, commented, “While US equities continue to rally, the sell-off in EM and European equities suggests market participants have partly priced in the risk of a trade war outside US markets. However, the slowdown in EM economic activity in the second quarter may have also dampened market sentiment towards EM as suggested by the inflection of the upward trend in earnings growth expectations since August.

“EM economic growth has decelerated since the beginning of the year (from 5.8% year-on-year in Q4 2017 to 5.3% year-on-year in Q2 2018) but remains high relative to developed markets, and surveys on economic activity (PMIs) have lost momentum while staying above the expansion threshold.

“Nevertheless, EM corporates’ earnings are high compared to prior cycles’ peaks while equity valuations are close to multi-year lows. EM equities are about 30% cheaper than developed market equities, based on relative long-term price/earnings ratios.”

Several EM countries have fallen on particularly tough times in 2018, including Argentina, Brazil, and Turkey. While some may think the hardships experienced by these large players jeopardize the entire EM ecosystem, BMO GAM’s Delledonne points to trends within ETF flows that suggest investors believe contagion risk to be low.

“We see low contagion risk from economically challenged economies…This was highlighted by minimal net outflows and large net inflows to several EM countries year-to-date, notably into China and South Korea focused ETFs, reflecting possible dip-buying strategies,” said Delledonne.

“Another example was when Turkey’s sovereign credit rating was downgraded by both S&P Global Ratings and Moody’s in September on the back of the weaker lira, rising inflation and a large current-account deficit. EM bonds fell across the board, but EM bond ETFs recorded modest net outflows over the week of the announcement, suggesting investors saw little contagion risk from Turkey to the rest of EM.”

Looking forward, Delledonne believes the medium-term outlook for EM equities is positive although she highlights several global factors including fluctuations of the US dollar, further slowdown in economic activity, ongoing trade disputes, and the pace of developed market monetary policy tightening which could each serve to bring further bursts of volatility.

“The US dollar should remain broadly stable, or only gradually appreciate on a trade-weighted basis, as the Federal Reserve normalises its monetary policy,” said Delledonne.

“The US dollar index has declined by 2.9% since mid-August despite strong economic growth in the US, suggesting this depreciation possibly reflects the widening of the US trade deficit (from $42bn in May to $51bn in July). Therefore, the potential knock-on effects of the trade negotiations for the US trade deficit are likely to have a greater influence on the dollar as we move forward into next year.

“The US-China trade dispute is likely to lead to a binary outcome, i.e. a trade deal or a trade war. If the US and China eventually come to an agreement in the coming months, it would likely benefit global equities and have limited direct economic impacts. On the other hand, if the trade dispute escalates we could see negative economic impacts in the medium-term with an increase in inflation from higher tariffs and a drag on the global economy.

“The IMF has estimated that the drag could amount to 0.5% by 2020 if the tariffs threatened by various trading partners are all implemented. In this pessimistic scenario, where the US cannot negotiate a trade deal with China, we would expect a correction in US equities as market participants realise that it could be a lose-lose situation. The possible rise of US inflation may force the Federal Reserve to increase interest rates more aggressively than anticipated, which will likely be disruptive for markets globally.”

In light of this outlook, Delledonne advocates the use of fundamental screening when approaching EM equities to reduce the risk of falling into a ‘yield trap’.

“Quality companies are less vulnerable to rising interest rates as they usually exhibit low leverage, superior profitability and lower earnings variability, which suggests they are aptly managed and can quickly adapt to economic changes,” she said.

“This is highlighted in the relative performance between the MSCI Emerging Market Index, and the MSCI EM Select Quality Yield Index, which focuses on three criteria: profitability, leverage and earnings’ quality, before selecting the top 50% companies exhibiting the highest dividend yield. Typically, the quality screen provides greater defensive characteristics in periods of bear markets, such as during the commodity crash in 2014 and 2015.”

BMO GAM offers the BMO MSCI Emerging Markets Income Leaders UCITS ETF (ZIEM LN) which tracks the aforementioned MSCI EM Select Quality Yield Index. The index methodology first identifies the 50% of constituents of the MSCI Emerging Markets Index scoring highest on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth and low financial leverage. A second step then selects the 50% of securities identified through the first step which have the highest dividend yield. The index rebalances on a semi-annual basis and is market capitalisation weighted with a 5% issuer cap.

ZIEM comes with a total expense ratio (TER) of 0.38% and has just $13 million in assets under management.

Other funds in this space include the Invesco FTSE Emerging Markets High Dividend Low Volatility ETF (EMHD LN) (TER 0.49%, AUM $17m), tracking the FTSE Emerging High Dividend Low Volatility Index, and the Franklin Templeton LibertyQ Emerging Markets UCITS ETF (FREM LN) (TER 0.55%, AUM $28m) referenced to a proprietary in-house index.