Exposure to Emerging Markets is often implemented with a single broad Emerging Markets ETF, like iShares’ EEM. However, with approximately 60% of the iShares Emerging Market ETF (EEM) assets allocated to only 4 countries, we set out to confirm that these top 4 countries are the most attractive countries in the MSCI Emerging Markets Index. The Accuvest “smart beta” approach under-emphasizes market capitalizations and instead focuses on systematically allocating to Emerging Market countries based upon the “relative attractiveness” of country level fundamentals, momentum, risk, and valuations.
Dave Garff’s research on evaluating country markets suggests that a balanced “smart beta” process “exhibits alpha across countries, not just within countries”. (See Multi-Style Global Equity Investing.) As of May 2014, the “smart beta” attractiveness of Brazil is lower than the 4th overall allocation it receives in EEM, and the “smart beta” attractiveness of Peru is higher than the 15th overall allocation (smallest allocation) it receives in EEM. These variations between attractiveness and market capitalization weight are at the heart of the “smart beta” vs. market capitalization debate. If Peru is more attractive than Brazil from a fundamental, momentum, risk, and valuation perspective wouldn’t it be logical to invest in a portfolio with more exposure to Peru than Brazil? The Emerging Markets ETF has an 11.7% weight in Brazil and a 0.5% weight in Peru. We see the same situation for Indonesia vs. Mexico and Turkey vs. Russia.
The chart below shows the “Smart Beta” attractiveness of individual countries ranked from most attractive to least attractive and their market capitalization. As you can see, the size of the country determines the allocation size of the country in the MSCI Emerging Markets Index and then subsequently in the iShares ETF – EEM. China, being the largest country in the Emerging Markets Index, gets the biggest weight, while Peru, being the smallest country, gets the smallest weight (blue bars below). Conversely, India is the most attractive country from a balanced “smart beta” approach, while Brazil is the least attractive.
From a balanced “smart beta” perspective, the most attractive countries in the Emerging Markets category include India, China, Indonesia, and Korea. After “x-raying” the EEM ETF and looking down into the underlying holdings, we found that the four largest allocations in EEM are China, Korea, Taiwan, and Brazil. By coincidence, EEM currently does a good job of providing exposure to 2 out of 4 of our most attractive countries. Nonetheless, EEM is currently “over-exposed” to Brazil, Mexico, and Russia, and to a larger extent “under-exposed” to India, Indonesia, Turkey, and Peru. When market capitalization based allocations diverge from “smart beta” attractiveness it creates an investment opportunity. Accordingly, we advocate exploiting this opportunity by allocating capital to the most attractive countries (on a balanced fundamental, momentum, risk, and valuation scale) rather than an index based portfolio that allocates capital based upon size.
Sources: Bloomberg, iShares, Accuvest Global Advisors
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