Morningstar Advisor - December 2013/January 2014 - (Page 46)

Spotlight Factor Investing in Emerging Markets By Patricia Oey Emerging markets ETFs that employ factor investing methodolgies avoid some of the drawbacks of cap-weighted approaches. Here are our top picks. The Vanguard FTSE Emerging Markets VWO and iShares MSCI Emerging Markets EEM exchange-traded funds, with assets under management of $52 billion and $44 billion, respectively, are larger than all other emergingmarkets ETFs and actively managed funds. risk-adjusted returns over the long term in emerging markets. These strategies also address some of the drawbacks of cap-weighting. They reduce exposure to governmentcontrolled entities and bring greater exposure to firms tied to local economies. But over the past few years, many investors have come to realize that those two funds aren't the best vehicles for exposure to the long-term growth opportunities in emerging markets, because of their market-capitalization weighting methodologies that tilt them toward large-cap stocks. That's because many of the largest companies in countries such as China, Brazil, and Russia are state-controlled firms that at times put political goals ahead of profitability. In addition, the ETFs' technology allocations, which account for about 15% of their portfolios, consist mostly of hardware and IT services companies that serve a global market place and are less driven by local market trends. Cap-weighting also results in a relatively low weighting of consumer firms-companies most likely to benefit from growth in domestic consumption. While these funds may offer a better exposure to emerging markets, they also come with their own set of risks. First, many of these funds and their underlying indexes have short track records. Second, these funds periodically rebalance, which can lead to significant portfolio changes. Rebalancing isn't always a problem, but it will require more monitoring by investors. (See "Following the Rules," Page 48.) Finally, and most importantly, there are many moving currents in emerging markets, such as currency volatility, government intervention in the private sector, and large-scale reforms. These issues are unpredictable. They not only have an impact on fund performance, but they affect portfolio construction. Recently, there have been a number of newly launched ETFs that seek to improve on market-cap weighted approaches by exploiting investment factors. Like they have in the United States, these factors-small cap, value, and volatility-have produced strong 46 Morningstar Advisor December/January 2014 That said, some funds make sense in a diversified portfolio. Below, we highlight our top picks among the passively managed, rules-based emerging-markets ETFs. WisdeomTree Emerging Markets Small Cap Dividend DGS The primary investment case for emerging markets small-cap stocks, aside from the small-cap premium, is that they offer better diversification benefits relative to large caps because small companies tend to have more exposure to local economies and customers than do large companies. While small caps usually connote higher risk, this WisdomTree fund's volatility has been lower than that of the large-cap-oriented MSCI Emerging Markets Index over the past five years. That is largely due to its quality tilt, which stems from its dividends-paid weighting methodology. (Dividends can signal effective management and healthy fundamentals.) While U.S. small caps can be young, speculative firms with little or no profitability, small caps in emerging markets tend to be wellknown, established players in their respective countries. The fund's dividend focus also means it has a value tilt, which may benefit long-term investors, as the value premium has also been observed in emerging markets. Since inception six years ago, the fund has provided higher absolute and risk-adjusted returns than the MSCI benchmark. We also like how the fund's dividend-weighted strategy has resulted in fairly stable country and sector allocations. Relative to the MSCI Emerging Markets Index, the fund is overweight stocks from Taiwan, Thailand,

Table of Contents for the Digital Edition of Morningstar Advisor - December 2013/January 2014

Morningstar Advisor - December 2013/January 2014
Contents
Contributors
Letter From the Editor
What’s Your Purpose?
Working for Gen Y
How to Allocate College Savings
Mobius Looks to a New Frontier
Investments á la Carte
Investment Briefs
How to Manage Bonds for Today and Tomorrow
Cloud Is the New Engine of Growth
Knowing Where to Look
Economic Vulnerability Varies by Country
Factor Investing in Emerging Markets
Following the Rules
Exploring Indexing’s Next Frontiers
Frequent Fliers
Family Blind Spots
Optimal Portfolios for the Long Run
Finding Value in a Pricey Sector
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
The Emerging-Markets Roller Coaster

Morningstar Advisor - December 2013/January 2014