VWO - Vanguard FTSE Emerging Markets ETF: Just Too Risky Right Now

• Rising inflation, deteriorating economic situation, and poor sovereign financial health pose tough challenges to the growth and revival of many emerging markets.
• China's zero-COVID policy and the threat of global military conflict over the China-Taiwan situation are the biggest downside risks for emerging markets.
• Surge in U.S. bond yields makes stocks unattractive and may jeopardize financial markets of emerging economies due to their dollar-denominated debt exposures.

The Vanguard FTSE Emerging Markets ETF ( VWO ) has a quite diversified portfolio and an extremely low expense ratio, which in general helps any exchange-traded fund ((ETF)) perform well in the long run. This ETF generated an average yield between 2 and 3 percent during the past 10 years. However, the quarterly payout has varied to a large degree, as the company stuck with the policy of generating a steady yield.

Vanguard Emerging Markets ETF has been quite volatile during this period. The stock had a strong recovery post the COVID-19 pandemic. Its price almost doubled within a year, and stayed at the same level for another year. However, since February 2022, the price has dropped by almost 25 percent. Overall, the return has been volatile for investors. On top of this, the economic, geopolitical, and fiscal situation of emerging markets are adding further pain to emerging market funds like VWO.

Vanguard FTSE Emerging Markets ETF & its Portfolio

Vanguard FTSE Emerging Markets ETF was launched and managed by The Vanguard Group, Inc., one of the largest investment managers worldwide. The fund was formed on May 4th, 1994 and is domiciled in the United States. The fund holds around 4,500 stocks , while its 10-largest positions account for only 19 percent of its assets. Currently the expense ratio is 0.08 percent. The fund tracks the FTSE Emerging Markets All Cap China A Inclusion Index, which includes equity shares of companies listed in 20 developing countries.

The FTSE Emerging Markets All Cap China A Inclusion Index is a market-capitalization-weighted index that is made up of approximately 3,550 common stocks located in emerging markets around the world. The group uses proprietary software to implement trading decisions that accommodate cash flow and maintain close correlation with index characteristics. Vanguard's refined indexing process, combined with low management fees and efficient trading, has provided tight tracking, net of expenses.

Vanguard Emerging Markets ETF select stocks and allocate funds into those by using representative sampling technique, meaning that the portfolio constitutes a broadly diversified collection of securities that, in the aggregate, approximates the index in terms of key characteristics. The portfolio implies a market-cap-weighted approach that presumably captures the market's collective opinion of each stock's value while mitigating turnover and trading costs. The portfolio's extensive diversification helps mitigate the impact of the worst-performing stocks.

Despite those benefits, emerging markets face greater risks than their developed counterparts. Political risks are more prominent in these markets than developed economies. Russia's recent invasion of Ukraine brought such risks to the forefront. Shortly after the invasion, FTSE removed Russian stocks from the fund's target index. However, Russian stocks represented only 3 percent of Vanguard Emerging Markets ETF at the end of January 2022. So, the impact was not that significant.

Fund's Performance During Q1, 2022

Volatility surged and stock markets slumped throughout emerging markets during Q1, 2022. Rising prices and the shortcomings of monetary policy to cope up with inflation were already weighing on market sentiment. On top of that, a Russian invasion of Ukraine injected substantial uncertainty into the markets. Energy prices soared, and resulted in a hike in consumer prices. Central banks of most economies raised short-term interest rates, and growth rates slowed down.

Stocks recovered some ground in March but finished the quarter down more than 5 percent, as measured by the FTSE Global All Cap Index. U.S. stocks performed roughly in line with the global market. Asia-Pacific stocks declined more modestly, and European and emerging-market stocks were among the laggards. Yields of U.S. Treasuries rose across all the maturity spectrum, with short term bonds becoming the most lucrative, given the prospect of more interest rate hikes by the US Federal Reserve. As a result of this, the average spread in yields between treasuries and corporate bonds widened.

FTSE Global All Cap ex US Index recorded a negative growth of 5.3 percent. Technology stocks were down by almost 13 percent, whereas healthcare stocks lost more than 11 percent during the quarter. Consumer discretionary took a hit because these stocks suffer the most during inflation, as these products can be done away with. The interest rate hikes proved positive for the financial sector, as financial stocks generated a growth of 7 percent.

As we know, during a scenario of looming recession, only the basic or core sector of any economy delivers steady growth. However, during Q1, 2022, only stocks belonging to basic materials delivered a close to double digit growth. Unfortunately the stocks from energy, utilities, real estate, and consumer discretionary failed to generate substantial returns. It seems that the sectors that benefitted from current political, economic and supply chain chaos are only two - financial and basic material. These two sectors account for only 30 percent of VWO's entire portfolio.

The China Factor: A Significant Threat to Global Growth and Stability

The Chinese economy and financial markets have long remained the growth leader among the emerging economies. However, of late the growth has slowed down. While the rest of the world is slowly returning to normal after two years of COVID-pandemic related disruptions, China's zero-COVID policy is becoming a challenge not only for China, but also for the entire world. More than 40 Chinese cities are believed to be under either a full or partial lockdown. As a result of lockdowns being extended from Shanghai to other cities, near-term economic downturn is becoming almost inevitable.

A much higher threat to the country's stock market in the long-term looms in the form of increased economic and political control from Beijing in response to growing public discontent arising out of stringent lockdown norms over such an extended period. Under such circumstances, the foreign funds tend to suffer the most. In addition to all these, the threat of global military conflict breaking out over the China-Taiwan situation ranks among one of the highest downside risks for global markets and the emerging economies over the next two to three years. At present roughly 52 percent of a total allocation of VWO is dedicated to the stocks listed in these two countries.

Investment Thesis

Going forward, the rising levels of inflation, deteriorating economic situation, and deeply eroded sovereign financial health will surely pose a tough challenge in the growth and revival of many emerging markets. Geopolitical risks such as Russian invasion of Ukraine, and a potential Chinese aggression on Taiwan, only add to the complications. In addition to all these, the Federal Reserve is on the verge of raising a series of interest rates.

The surge in U.S. bond yields has dramatically improved the relative outlook for bonds, particularly from a risk-adjusted perspective. Higher interest rates may also jeopardize the financial markets of those emerging economies, as numerous emerging economies have significant dollar denominated debt exposures. Thus, despite numerous positives, such as a deeply diversified portfolio and an extremely low expense ratio, the risks involved with the Vanguard FTSE Emerging Markets ETF are too high to ignore.

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