FEMS - FEMS: This Small-Cap Emerging Market Fund Fails To Generate Interest

2023-03-19 07:20:17 ET

Summary

• FEMS offers investors an option to invest in some potential alpha generating small-cap equities in diversified sectors in the emerging market economies.
• 70 percent of FEMS’s investments are in Turkey, Taiwan, China, and Brazil. 65 percent is invested in basic materials, energy, industrial & technology sectors.
• FEMS pays a quarterly dividend with a decent but inconsistent yield. Since 2013, its yield ranged between 1.9 to 6.5 percent, and seems unsustainable.
• FEMS is a risky fund and annual average total return of 3.94 percent over the past 5 years is not enough to attract growth-seeking investors.

~ by Snehasish Chaudhuri, MBA (Finance)

First Trust Emerging Markets Small Cap AlphaDEX Fund ( FEMS ) is an exchange traded fund that seeks to track the performance of the NASDAQ AlphaDEX Emerging Markets Small Cap Index, by using full replication techniques. The index is a fundamentally weighted index that comprises dividend paying small-cap stocks from emerging markets. In general, both emerging market funds and small-cap funds bear higher risk than large-cap US based funds. FEMS comprises more than 200 equity stocks and generates a decent enough yield. However, its total return is not at all impressive over the long run. FEMS has an AUM of $291 million, and has an expense ratio of 0.8 percent. The fund is currently trading almost at par with its Net Asset Value.

Stocks in FEMS Selected to Create Positive Alpha or Risk-Adjusted Returns

First Trust Emerging Markets Small Cap AlphaDEX Fund invests in growth and value stocks of small-cap stocks of companies operating across diversified sectors. It normally invests at least 90 percent of its net assets (including borrowings) in the common stocks, depositary receipts, real estate investment trusts and preferred shares that are included in the NASDAQ AlphaDEX Emerging Markets Small Cap Index. This index is composed of stocks that are part of NASDAQ Emerging Markets Index through the use of the AlphaDEX selection methodology. AlphaDEX is proprietary, rules-based methodology designed to produce similar risk characteristics as that of broader market indices while attempting to outperform those indices in terms of total returns. Stock selection is aimed at generating positive alpha or risk-adjusted returns.

Composition and Performance of Top Holdings of FEMS’s Current Portfolio

Among the emerging markets, FEMS invests primarily in Turkey, Taiwan, Brazil and China. These four emerging markets have good growth potentials. More than 70 percent of its assets are invested in these markets. Almost 28 percent of the First Trust Emerging Markets Small Cap AlphaDEX Fund is also invested in stocks from basic materials and energy sectors. These four economies are rich sources of basic materials and some energy resources. Another 37 percent of FEMS’s assets are invested in stocks from industrial and technology sectors. China and Taiwan are again known for their growing base of small-cap technological and industrial companies. Although Turkey and Brazil don't possess a strong economic prospect at present, all these four economies are not facing any major geo-political and existential challenges.

Major holdings from those emerging markets included mostly Turkish stocks - Low-cost airlines Pegasus Hava Tasimaciligi ADR ( OTCPK:PEGHY ), Cement manufacturer Cimsa Cimento Sanayi Ve Ticaret A.S., diversified conglomerate DOGAN SIRKETLER GR ( OTCPK:DSGUF ), Investment bank IS Yatirim Menkul Degerler AS, energy and utilities firm Enerjisa Enerji AS, industrial and financial conglomerate Haci Omer Sabanci Holding AS, beverage firm Anadolu Efes Biracilik ve Malt Sanayii Anonim Sirketi ( OTCPK:AEBZY ), supermarket chain Migros Turk TAS, agricultural chemicals and veterinary product manufacturer Hektas Ticaret AS, tractor manufacturer Turk Traktor ve Ziraat Makineleri AS, home and professional appliances manufacturing company Vestel Elektronik Sanayi ve Ticaret AS and retail discount stores chain Sok Marketler Ticaret AS.

Mexican grocery and department store chain Grupo Comercial Chedraui S.A.B. de C.V. ( OTCPK:GCHEF ), Polish coal manufacturers Jastrzebska Spolka Weglowa SA ( OTCPK:JSZWF ), Polish telecommunications giant Orange Polska S.A. ( OTCPK:PTTWF ), Taiwanese integrated circuits manufacturer Fitipower Integrated Technology Inc., are some other notable investments by First Trust Emerging Markets Small Cap AlphaDEX Fund. Large proportion of these stocks recorded exceptionally high positive price growth during the past five years. During the past 12 months too, all the above-mentioned 10 Turkish stocks generated strong price growth, despite the broader market indices performing poorly.

So, overall top holdings of First Trust Emerging Markets Small Cap AlphaDEX Fund performed remarkably well both during the short run as well as the long run. Unfortunately, the fund invested only about 1 percent of its assets in each of these stocks. Together these 16 stocks accounted for only 18 percent of FEMS’s portfolio. Chinese, Taiwanese and Brazilian stocks didn’t perform that well during the same period. As a result, this small-cap EM fund failed to impress. Its price return stood low at 0.55 percent during the past 12 months and 18.4 percent during the past five years. As average yield was not strong and was inconsistent, total return was also quite unimpressive at 3.9 percent.

EM Small-Cap Funds May Have Growth Potential, But Possess Higher Risk

First Trust Emerging Markets Small Cap AlphaDEX Fund was launched and is managed by First Trust Advisors L.P. The fund invests in public equity markets of global emerging regions. This EM fund was formed in February 2012 and is domiciled in the United States. Many investors have a favorable investment outlook for EM stocks compared to other equity markets. Once interest rates and inflation stabilizes and the Chinese economy opens up, emerging markets will be in a position to deliver higher growth. However, it's very difficult to obtain data related to small-cap emerging market indices. Moreover, emerging markets stocks are considered riskier than US or other developed markets. Small-caps are considered riskier than both large-cap and mid-cap stocks. That's why investing in the right sectors and the right markets matters a lot.

Investment Thesis

First Trust Emerging Markets Small Cap AlphaDEX Fund offers investors an option to invest in small-cap equities in diversified sectors in the emerging market. Almost 70 percent of this fund’s investments are in Turkey, Taiwan, China, and Brazil. Sector wise, 65 percent of its assets are invested in equities from four sectors - basic materials, energy, industrial, and information & communication technology (ICT). These four economies are rich sources of basic materials and some energy resources. Chinese and Taiwanese economies are again known for their technology and industrial companies. Small-cap firms in those sectors are thus having a decent growth potential.

In my opinion, FEMS is a risky fund, despite its well-diversified portfolio. The fund is trading at $37.2, almost at par with its net asset value. The fund pays a quarterly dividend with a decent yield. However, the yield of FEMS has never been stable. Over the past ten years, yield has ranged between 1.9 percent to 6.5 percent. So, there lies a big question over the sustainability of its yield, since it has not been consistent enough. Although the average yield over those ten years stood as 3.65 percent, income-seeking investors can’t rely on this fund for their quarterly earnings. Annual average total return is also not strong enough in order to attract growth-seeking investors. Average total return between 2018 and 2022 was less than 4 percent. In my opinion, First Trust Emerging Markets Small Cap AlphaDEX Fund should better be ignored.

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