When InvestorPlace readers chose the iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) at the end of 2018, the sentiment was high that exchange-traded funds with heavy emerging markets holdings would be the best ETFs of 2019. But unfortunately for the No. 7 spot EEM ETF, U.S.-China trade war concerns rage on.
Up just under 5% year-to-date, it’s looking highly unlikely that EEM could take on the current leader. InvestorPlace’s Vince Martin selected the iShares U.S. Home Construction ETF (BATS:ITB) — and his pick is up over 43% since the start of the year.
While the reader’s choice ETF pales in comparison, I believe that in the longer term — or in a different year — EEM could have been the best pick. This means that in 2020, or whenever trade troubles subside, it’s worth another look.
Trade Woes Weigh Down EEM
As an emerging markets ETF, 81% of EEM’s holdings are from emerging markets and 17% are from non-U.S. developed markets. Unsurprisingly, as the emerging markets thesis has long been resting on positive relations between the U.S. and China, 30% of EEM’s holdings are based in the latter nation. Big names like Alibaba (NYSE:BABA) and Tencent Holdings (OTCMKTS:TCEHY) account for 4.5% and 4.6% of EEM, respectively. Also unsurprisingly, this weighting easily illustrates how geopolitical strife has weighed down the EEM ETF.
To be fair, YTD, EEM is still in the green. But in the last three months, the ETF is down almost 4%. In this period, not a day has gone by without a reference to the ongoing trade war in major headlines. President Donald Trump threatened to impose 10% tariffs on an additional $300 billion of Chinese goods, and then in a surprising move, delayed them.
But wait, there’s more. As many in both nations called for peace, Trump said he was willing to consider an interim trade agreement. Both nations expanded lists of goods exempt from new tariffs. As of Sept. 23, the U.S. has levied tariffs on $550 billion in Chinese goods. In turn, China has levied tariffs on $185 billion in U.S. goods.
Through tweets, United Nations speeches and offhand comments to members of his administration, Trump’s stance on solving the trade crisis fluctuates dramatically. Just this week, he stoked the fire once more when he implied that China would bring a “bad deal” to the table in interim deal negotiations. Will Trump and Jinping ever be able to reach a favorable agreement?
The Case for Emerging Market Funds
Looking at EEM’s YTD performance and considering the uncertainty that lies ahead with the trade war, why should investors still consider the emerging markets thesis? In my interview with Niagara University’s Dr. Tenpao Lee, who serves as a full professor of economics and was named a Shanghai Distinguished Oversea Professor, he emphasized that there is much more to consider. For example, the Fidelity Emerging Markets Fund (NASDAQ:FEMKX) is up 20% year-to-date. While FEMKX still has 25% of its holdings in China — and its two top holdings are also TCEHY and BABA — it has 14% in India and 12% in Brazil. EEM’s second- and third-ranked countries are South Korea and Taiwan, each contributing 12%.
According to Lee, this regional diversity in FEMKX’s holdings is currently giving it an edge. And while the short-term effects of the trade war are hurting Chinese stocks and EEM, he believes the next two or three years will bring growth — potentially at a massive level — to China-based emerging market funds.
Why? China’s current response to the trade war has been to focus on gaining economic independence. Instead of importing agricultural products, it leased new land and it has started a farming venture. When importing U.S. tech products became more expensive, companies like Huawei and Xiaomi (OTCMKTS:XIACY) were poised to benefit. Now these companies are even further expanding into the European markets.
“There is tremendous room for the Chinese economy to grow, and it has the incentive to grow,” Lee said. “In the future, like in one or two years, if China really develops itself — and if it is a big portion of the emerging market ETF — that ETF will do very good. So that [future performance] is up to whether you think China will get over the hurdle of the trade war.”
So for readers who saw EEM as a compelling choice, there are two future options. One, find a similar fund with more regional diversity to mitigate the trade war’s impact. Or two, wait for a resolution knowing that it’s likely EEM’s future returns will reflect China’s investment in its domestic economy.
Beyond the Trade War
In acknowledging EEM’s lackluster YTD performance and making the case for its long-term potential, it’s important to note that there are risks that go beyond the trade war.
For instance, any other rumblings of political instability in China or in the region could bring down the ETF. Over the summer, news from Hong Kong took a toll on the markets — and protests still continue in Hong Kong after the withdrawal of Chief Executive Carrie Lam’s controversial extradition bill. News of the bill’s withdrawal stabilized Hong Kong’s stock market. And investors around the world breathed in a sigh of relief. But as protesters wrap up their 17th week, the future is certainly unclear.
Similarly, any disturbances in China’s relationship with Taiwan (tied for second in EEM’s country weightings) could spell bad news for the ETF.
Bottom Line on the Reader’s Choice ETF
While it’s looking pretty clear that EEM won’t be one of the best ETFs of 2019, there’s some good news.
BABA stock is up over 23% YTD and TCEHY stock is up 8.7% in that time period. There’s no doubt that these names — and a handful of other Chinese stocks — are set for success. As Lee argues, the trade war’s impacts on China’s economy will force growth, which should boost EEM.
It’s not going to be a winner this year, but long-term investors should still see reason to believe in EEM and in a China-focused emerging markets thesis.
Sarah Smith is a web editor at InvestorPlace.com. As of this writing, she did not hold a position in any of the aforementioned securities.