By David Stevenson –

In this column I am going to touch on the rather sensitive and controversial subjects of emerging markets (EM) and smart beta. Crucially, I want to argue that investing in EM equities could have been a far more rewarding pursuit over the last 12 months if (and it’s a big if) you’d have focused on the right kind of stocks.

Emerging market woes put smart beta to the test.

My journey starts with a research paper on emerging market volatility from US-based emerging markets ETF specialist Emerging Global Advisors (EGA).

In this paper the analysts at EGA make what I think is a very strong case. Everyone may talk about whether EM stocks are a good idea, but what they talk about and what they do are very different matters.

In practice, portfolio exposure directly to EM equities (ignoring EM exposure through developed market stocks) is actually very low i.e. investors do not actually own many EM stocks in their portfolio. What puts them off? Clearly not fundamentals, as most emerging markets are currently trading at chunky discounts to US stocks.

In reality, volatility is the real killer. How often have we heard the retort that Chinese shares look cheap but they could get even cheaper “because Chinese stock markets are very volatile”? In truth, that view is absolutely correct. Nevertheless, it is a broad-brush statement and, inevitably, there are huge variations. The EGA analysts, for instance, rightly point out that most volatility in EM stocks comes from investing in just a few key sectors – financials, energy and miners. Volatility also varies amongst EM countries – Russia, Brazil and India, for example, tend to be more volatile than, say, Malaysia or Thailand.

Strip out these country and sector-based sensitivities and look beyond the BRICs or focus on just defensive, consumer-orientated stocks…. and hey presto, that volatility suddenly falls away sharply.  At which point, of course, we’re starting to enter the territory of smart beta.

Enthusiasts for smart beta talk about tilts away from (or towards) certain sectors, geographies, sensitivities or volatilities in order to enhance equity returns. The good news is that these smart beta-esque ideas can be put to the test in the world of emerging markets and although it’s still very early days in terms of quantity of annual data (excluding back-tested data), we can at least begin to make some early judgements on the usefulness of these kinds of EM ETFs.

Crucially, in the US market in the past few years we’ve seen an absolute explosion of new emerging market ETFs that focus on everything from technical momentum (e.g. PowerShares DWA Emerging Markets Technical Leaders Portfolio ETF (PIE)), through to minimum volatility (e.g. iShares MSCI Emerging Markets Minimum Volatility ETF (EEMV)), and even combinations of factors (e.g. EGShares Low Volatility Emerging Markets Dividend ETF (HILO)). We’ve also got ETFs that offer exposure “beyond BRICs” (e.g. EGShares Beyond BRICs ETF (BBRC)); ETFs which focus on consumers (e.g. EGShares Emerging Markets Consumer ETF (ECON)); and, my own personal favourite, ETFs linked to equally weighted indices (e.g. Guggenheim MSCI Emerging Markets Equal Weight ETF (EWEM)).

Virtually all major smart beta strategies are in evidence with some early performance and risk numbers to back up any analysis. After filtering out the country and regional funds and looking only at the larger, more actively traded ETFs, what really interests me is whether a style or sensitivity tilt has actually helped investors over the last, difficult 12 months i.e. the one period over the last ten years where you would probably have wanted a smart beta tracker to have given you an edge in emerging markets.

So what do the numbers say? Well, without blinding you with a load of data, over both the past year and the last three months (i.e. not good times to be investing in EM equities) the bottom line is that it does appear to be the case that smart beta has added value.

If one wanted to be very simplistic, one could look at the returns over the last 12 months of two of the largest plain vanilla ETFs in the EM space, the Vanguard FTSE Emerging Markets ETF (VWO) and iShares MSCI Emerging Markets ETF (EEM), and see that they lost a nasty 4-6% compared to EGShares ECON, which tracks the Dow Jones Emerging Markets Consumer Titans 30 Index, which delivered a positive return of around 6.5%. But this rightly popular fund (it has more than $1 billion in assets) is not alone in producing positive absolute returns –PowerShares PIE and EGShares Emerging Markets Domestic Demand ETF (EMDD) also knocked out positive returns. iShares EEMV was marginally negative but nonetheless delivered its return with lower volatility.

But we also need to look under the skin – not just at the last 12 months but also at the last one to six months – and examine the risk attributes of these smart beta heroes. What emerges is that they have, by and large, delivered superior returns with lower volatility. It’s worth pointing out that total expense ratios of these funds tend to be substantially above core plain vanilla ETFs. Still, I think an extra 50 basis points in expenses may be worth paying if you’re potentially going to get a return that is perhaps 5% or even 10% better than the cap-weighted mainstream (as a disclaimer, I will remind investors of the old mantra, “past performance is not a guide to future performance” etc).

These funds also demonstrate that investing in emerging markets didn’t have to be an exercise in utter futility and despair in the last 12 months – a crucial period of time where I would have wanted smart beta to deliver – and validate what I think are the two core insights of the EGA paper, namely that a focus on lower volatility stocks and exposure to domestic consumer demand sectors will deliver value.

Of course, there is one important caveat to all this! No matter how smart your EM tracker, it would still have underperformed a plain vanilla S&P 500 ETF. Smart beta is a great idea for the long-term investor but it won’t save you from making poor tactical asset allocation decisions!

The views and opinions expressed herein are the views and opinions of the author, David Stevenson, and do not necessarily reflect those of ETF Strategy.