VWO - 4 Emerging Market Trends Impacting VWO

2023-07-20 12:28:48 ET

Summary

• Equity markets have seen strong, double-digit capital gains this year, with emerging market equities being an exception with weak, inconsistent single-digit gains.
• Despite recent underperformance, emerging market equities offer investors cheap prices and good growth prospects, making them a good buy for the future.
• Vanguard FTSE Emerging Markets Index Fund ETF Shares is an emerging market equities index fund, providing diversified exposure to said asset class.

Equity markets have had an outstanding year, with most countries, industries, regions, and equities seeing strong, double-digit capital gains. Emerging market equities have been one of the few exceptions, with these seeing weak, inconsistent single-digit gains, significantly underperforming other market segments.

Although recent underperformance was a negative for shareholders in the past, it is something of a benefit for investors in the future. Emerging market equities currently offer investors very cheap prices and valuations, and growth prospects are good too. Momentum is, understandably, quite weak, although not terrible. In my opinion, emerging market equities are buys, although the lack of momentum or clear catalysts means significant short-term gains seem unlikely.

I'll be focusing on the Vanguard FTSE Emerging Markets Index Fund ETF Shares ( VWO ) for the rest of the article, but everything here should apply to most emerging market equity funds in roughly equal measure.

VWO And Emerging Markets Equities - Overview And Analysis

Index and Holdings

VWO is an emerging market equity index ETF, tracking the FTSE Emerging Markets All Cap China A Inclusion Index . It is a relatively simple index, investing in all relevant emerging market equities meeting a basic set of inclusion criteria. It is also a relatively broad index, which results in an incredibly well-diversified fund, with investments in over 5000 securities:

It has exposure to most relevant industry segments:

The exposure extends to dozens of countries:

As is the case for most emerging market equity funds, VWO is significantly overweight China, due to the size of the country's economy. It is also overweight Taiwan, due to the size of the country's public equity's market, and due to the large size of Taiwan Semiconductor Manufacturing Company Limited ( TSM ). TSM accounts for around 6.0% of the value of the fund, almost twice the weight of the second largest holding, Tencent ( OTCPK:TCEHY ), and is one of only four holdings with a weight of 1.0% or more.

In my opinion, VWO's overweight position in these two countries is a negative, as it would almost certainly result in significant losses during any potential / future Chinese invasion of Taiwan. Although an invasion is far from certain, it is a distinct possibility, and one which investors should take into account. Keeping position sizes small, or complementing VWO with less China-centric ETFs like the iShares MSCI Emerging Markets ex China ETF ( EMXC ), seems wise, in my opinion at least.

As is the case for most international ETFs, VWO is overweight old economy industries like materials and financials, underweight tech and healthcare. Said industry tilts are reflective of underlying economic conditions and tilts. Lots of steelmakers and banks in Brazil or China, fewer tech companies or pharmaceuticals.

These industry tilts impact the fund's performance, with VWO underperforming when tech outperforms, as has been the case YTD:

and with the fund outperforming when tech underperforms, as was the case in 2020:

Besides the above, not much else stands out about VWO's index or holdings. The fund is a simple, broad-based emerging market equity ETF, with all that entails.

Weak Momentum

U.S. equities had an outstanding run from early 2009 to late 2021, seeing annualized returns of +15%, with cumulative returns of almost 600% .

By late 2021, U.S. equity valuations were stretched. The S&P 500 (SP500) traded with a 20.0x - 22.0x P/E ratio, around 30% higher than average:

Growth stocks were very expensive too, reaching levels last seen in the dot-com bubble (but still below these):

By early 2022, higher inflation and interest rates had turned investors bearish, and caused a shift away from unprofitable, expensive tech, to profitable, cheap industries and stocks.

International stocks outperformed, too, but by much less, and much more inconsistently so:

Importantly, emerging market equities were an exception to the above, with these stocks matching the performance of the S&P 500 during 2022:

and significantly underperforming since mid-2021:

Recent underperformance is a negative in and of itself, and also a negative insofar as it is evidence of bearish market sentiment and a lack of momentum. I think there is a lot of merit to emerging market equities right now, for reasons we'll soon see, but the market does not seem to agree, and it is the market that prices these securities.

Cheap Prices and Valuations

Emerging market equities currently trade at a sizable discount to U.S. and international equities, due to their greater level of risk, and due to recent price weakness. Discounts are particularly large vis-à-vis large-cap U.S. equities, nearing 50%.

Cheap valuations could lead to significant capital gains, contingent on valuations normalizing. This has not been the case in the recent past, with emerging market equities underperforming for the past few years, as previously mentioned. I see few catalysts for renewed interest or increased demand for emerging market equities, too, besides general economic growth.

Considering the above, focusing on high-dividend emerging market equities seems wise. Dividends are (generally) less volatile than capital gains, and less dependent on market sentiment too. I've been bullish on the iShares Latin America 40 ETF ( ILF ), with a 8.5% yield, in the past, and the fund has performed quite well since. For more diversified funds, the WisdomTree Emerging Markets High Dividend Fund ETF ( DEM ) is another good choice, with a 7.3% yield.

VWO and other emerging market equities also benefit from an expensive dollar / cheap foreign currency prices. From looking at Fed data , and JPMorgan Chase ( JPM ) data , it seems that these are currently 10% higher than their historical averages, but there is a lot of volatility in these figures.

If prices normalize, emerging market equity investors could see up to double-digit capital gains. Lower Fed interest rates would likely cause prices to normalize, by decreasing demand for dollar-denominated financial assets, but this seems incredibly unlikely in the short-term, as per Fed guidance.

Notwithstanding the above, the cheap price and valuation of VWO and other emerging market equities could lead to significant capital gains moving forward, and is an important benefit for shareholders.

Growth Prospects

Cheap stocks are sometimes slow-growth stocks, but that is mostly not the case for emerging market stocks. VWO's underlying holdings have seen annual earnings growth of 14.0% these past few years, a strong rate, although a bit lower than the 18.3% of the S&P 500.

Growth for VWO:

Growth for the S&P 500:

Emerging market equities, as a whole, have / are likely to benefit from high economic growth . Chinese stocks have benefitted from the government's pivot back to tech , while TSM benefitted from higher demand for chips .

VWO's good growth prospects are something of a benefit for shareholders, especially insofar as these are somewhat misaligned with the fund's valuation. VWO trades with a large discount, but growth is only moderately below-average. Under these conditions, the fund's valuation gap could narrow, but the same would not be true if growth was stagnating, or earnings decreasing.

Conclusion

Emerging market equities currently offer investors very cheap prices and valuations, with good growth prospects. On the other hand, momentum is weak, and catalysts few. Vanguard FTSE Emerging Markets Index Fund ETF Shares is one of the largest, most well-known emerging market equity ETFs in the market, with the same characteristics of its underlying holdings.

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