Should You Flee Emerging Market ETFs?

by Carla Lake | September 6, 2013 7:45 am

Just last week, emerging market ETFs saw $3.9 billion in outflows[1]. In fact, August was the worst month for emerging markets ETFs (and ETFs in general[2]) since 2010. Is this a sign to drop risky emerging markets like a hot potato (or dumpling, as the case may be)?

Not so fast[3], says Richard Band, editor of the value newsletter Profitable Investing.

“The shoe was on the other foot from 2002 to 2007. Back then, the NYSE lagged far behind other global bourses, and investors thronged to international mutual funds.

I can’t tell you the day or the hour when the pendulum will swing the other way again. What I do know is that equity values overseas have substantially improved. Emerging markets in particular are so cheap that it wouldn’t take much of a catalyst to trigger a major bounce.”

This summer, big-name talking heads like Jim Cramer have been all about investing in America[4]. But when it comes to finding a bargain-basement value, you need to buy when there’s blood in the streets.

Let’s take the emerging markets ETF with the most assets under management[5] for example — the Vanguard Emerging Markets ETF (VWO[6]). It’s currently trading at 12.9x P/E and 1.7x price-to-book ratio, right on par with the index it tracks, the FTSE Emerging Markets Index.

Compare that to the S&P 500 ETF’s  (SPY[7]) P/E of 16.59x and 2.35x price-to-book ratio. And based on the fact that trailing reported earnings and corporate profits are well above the historical trend[8], domestic equities aren’t likely to hand you spectacular returns anytime soon.

However, despite the upside potential in a discounted area, emerging markets aren’t likely to be a smooth ride. VWO has lost 13.5% YTD, seemingly tracing an inverse path to the 16.4% gain in the SPY. And with nearly 50% of its portfolio centered on Brazilian and Chinese (including Taiwanese) equities, you might be worried about putting all your eggs in one basket with a fund like VWO. Dan Wiener of the Independent Adviser for Vanguard Investors describes the risk/reward picture here well:

“Over the past decade the fund has not put in a single-digit annual gain or loss. In other words, returns have been either really good, as the 2009 and 2010 rebound demonstrated, or really bad, such as 2008 when shareholders lost over 50% on their way to a -62.7% MCL [maximum cumulative loss].”

9 4 13 etf 300x162 Should You Flee Emerging Market ETFs?[9]

Chart generated with the Google Public Data tool. Data from the World Bank.

But according to the World Bank, both of these countries have a greater GDP growth — 2.7% for Brazil and 7.7.% for China — than the U.S., which has a GDP growth rate of 1.7%. Granted, I’m just using VWO as an example, but over time, emerging markets funds simply have greater room to run … and with values so low right now, it seems like they can only go up from here.

So which would you rather buy right now: the potential for huge growth at a discounted price, or a market that’s overvalued and not likely to make any big moves soon? I know which ETF I’ll be researching further.

As of this writing, Carla Lake did not hold a position in any of the aforementioned securities.

Endnotes:
  1. $3.9 billion in outflows: http://www.etftrends.com/2013/09/emerging-markets-etfs-stung-by-outflows/
  2. ETFs in general: http://online.wsj.com/article/BT-CO-20130830-709814.html?mod=wsj_share_twitter
  3. Not so fast: http://investorplace.com/2013/07/see-the-value-of-emerging-markets/
  4. investing in America: http://www.cnbc.com/id/100843159
  5. most assets under management: http://etfdb.com/screener/#asset-class=Equity&equity-regions=Emerging_Markets
  6. VWO: http://studio-5.financialcontent.com/investplace/quote?Symbol=VWO
  7. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY
  8. well above the historical trend: http://pragcap.com/further-evidence-of-an-overvalued-market
  9. [Image]: http://investorplace.com/wp-content/uploads/2013/09/9-4-13-etf.png

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