One of my favorite exchange-traded fund writers, Todd Shriber of ETF Trends, recently highlighted the news that Russell Investments would be updating its FTSE Emerging Market Index to include greater China exposure. I have mixed feelings about this move for several reasons that I will get into in a moment, but first, let’s explore the immediate effects of this transition.
The number one fund that this will impact is the Vanguard FTSE Emerging Markets ETF (VWO), which is the largest broad-based emerging market ETF with over $50 billion in total assets. I actually own this fund for clients in my Opportunistic Growth portfolio, which is why this change hits close to home.
VWO currently has exposure to 1,027 stocks spread out over 20 countries. The number one country allocation is China, with 28.6% of the total assets. All of this exposure is currently in American depositary receipts that are traded on international exchanges in the form of B-shares, H-share, P Chips and Red chips.
The initial change is set to bring coveted A-shares (traded on the Shanghai and Shenzhen exchanges) to VWO with a 5% allocation once the appropriate regulatory moves have been made. That would increase the total China allocation to approximately 32%.
However, over the long-term, the FTSE Emerging Markets ETF is set to increase its Chinese exposure up to as much as 50% of the total portfolio. This secondary update will be made once the restrictions have been lifted on the amount of A-share securities that foreign investors can own.
Now, the Chinese stock market has been on fire this year, and the opening up of additional A-share allocations is a big move for international markets. However, the proposed 50% weighting toward China will ultimately skew the benchmark heavily in one market. In addition, this change will significantly diminish the impact of important countries such as Taiwan, India, Russia and Brazil.
VWO will no longer have the feel of a broad-based emerging market index. It will be more of a “China index with some other countries on the side” fund, which will be fine as long as the momentum stays with China — everyone benefits in that situation.
However, if the tide turns and the economy experiences a significant slump, it’s going to heavily impact this new overweight index.
It’s still to be determined whether MSCI will ultimately update the second largest fund in this space, the iShares MSCI Emerging Markets ETF (EEM). MSCI may choose to stand apart for competitive purposes or look to follow suit in order to keep up with the competition.
Either way, it may send investors scrambling to look at alternative emerging-market ETFs for broad-based exposure. The iShares MSCI Emerging Markets Minimum Volatility ETF (EEMV) is potentially a solid substitute if MSCI doesn’t adopt the same China-heavy exposure as FTSE. This ETF invests in a broad basket of emerging market stocks with historically less volatility than its peers. EEMV also has a very reasonable expense ratio of 0.25%.
There are also various smart-beta or fundamentally practical indexes such as the WisdomTree Emerging Markets Equity Income Fund (DEM) that might warrant a second look at well. DEM invests in an index of high-yield emerging-market equities that are dividend weighted within the portfolio. However, one potential drawback to this fund is the significantly higher expense ratio of 0.63%.
It’s always important to keep an eye on what you own within an ETF so you don’t wake up one day caught unaware of major changes that significantly skew performance. Sometimes those changes can be for the better and other times they are made at tactically inopportune times.
These transitions also provide a solid reason to survey the landscape of available ETF choices, and make sure that you are invested in the right areas for the right reasons.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. To get more investor insights from FMD Capital, visit their blog.
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