VWO - VWO: Time For Emerging Markets But Choose Wisely And Opt For FRDM

2023-05-08 10:34:56 ET

Summary

• With high inflation concerns on the one hand and financial stability on the other, central banks on both sides of the Atlantic Ocean have to tread carefully.
• Emerging markets (EM) do not seem to have this problem making funds like Vanguard's VWO seem attractive for diversification purposes.
• However, looking at geographical exposure and comparing it with another EM fund, I identify China as a source of volatility that could persist after recent data restrictions.
• I identify FRDM as an alternative ETF which offers lower volatility and higher dividend growth for more risk-averse investors.
• In addition to country exposure, the assessment is also based on dollar strength and shows that it is wiser to get indirect exposure to China through countries that export commodities to it.

With central banks on both sides of the Atlantic Ocean busy taming inflation and now having to make sure that they do not deteriorate things further along the liquidity front, especially in America after the banking turmoil , economic conditions have become more unstable.

In this case, instead of painstakingly fishing for the best stock to navigate volatility in the developed world, a wiser strategy would be to look toward emerging markets or EM. In this case, investing in the Vanguard FTSE Emerging Markets Index Fund ETF Shares ( VWO ) which is still below its pre-pandemic peak of $45.6 by more than five dollars could also represent a strategic choice for diversified portfolios.

However, given that the stocks in EM normally exhibit higher volatility than their developed country counterparts, I make sure to balance the risks involved with opportunities after China reopened for business subsequent to the Covid freeze, as well as provide an alternative for risk-averse investors.

Emerging Markets are Synonymous with Volatility

When investing in EM, there always seems to be a crisis somewhere as illustrated by the volatility in VWO's blue chart below during the last three years. Now, its holdings certainly benefited from the loosening of monetary policy by central banks throughout the world in the aftermath of the Covid market freeze. However, unlike the S&P 500 whose upside continued well into 2021, the Vanguard ETF's performance started to sputter much earlier as Covid persisted in China after the initial success by the country's authorities in controlling the disease with their tough social distancing measures.

Subsequently, last year's turmoil began with Russia's invasion of Ukraine, which led to the crumbling of Russian stocks. This invasion was followed by a rally in Chinese equities in the second quarter when the stringent COVID-19 containment measures began to ease. The optimism quickly faded as a few new cases of COVID-19 prompted the authorities to impose the zero COVID policy when major cities were placed in lockdown mode, thereby crippling the economy with consumer discretionary stocks tumbling.

However, EM economies were not the only ones to face challenges in 2022 as the outlook for exports started to become bleak as growth in the world's most powerful economy started to look vulnerable, as a result of the Federal Reserve's aggressive rate hikes.

The anticipation of a slowdown in global demand has led to considerable declines in stocks of global manufacturers like Taiwan Semiconductor Manufacturing ( TSM ), VWO’s top holding as pictured below. It lost nearly 8% in the last year despite demand in the automobile sector remaining strong and chips being critical components for industrial production throughout the world.

Thus, the semiconductor cycle suffered from some pullback in customer orders and destocking in the second half of 2022. More recently, new technology like generative AI seems to have given new impulse to the sector with demand likely to be driven by Microsoft ( MSFT ) and Alphabet ( GOOG ) (GOOGL) which depend on chips for their underlying intelligent infrastructures.

Holdings and China's Weight

For this purpose, China's reopening is a positive as it is the world’s top consumer of semiconductors. Also, as the factory of the world, there should be an increased demand for commodities across the board which is good for commodity-exporting countries like Brazil, Chile, and South Africa which constituted a combined 9% of VWO’s underlying fund as pictured below, but below China's sizeable 35%.

To be realistic, do not expect a dramatic increase in demand, but rather growth at the margin or incremental profits following more sales, as the recovery is likely to be uneven. Thus, in the first quarter of 2023, the value-added services sector grew by 5.4% YoY helped by more people traveling, while it was more subdued in manufacturing and construction, at only 3.3%. There is also uncertainty concerning jobs, but inflation was at only 0.7% in March.

Furthermore, do not forget that in China, it is the communist party that reigns.

As such, do not expect the same type of approach towards regulation and free access to information as in the U.S. and other democracies with the latest example being Wind Information, China's biggest financial data provider curtailing access to certain business and economic data to offshore users (or those not residing in China). This is part of the country’s cybersecurity regulators putting in place new data rules.

Now, for investors used to regular updates in order to assess market moves, this may be hard to digest especially if they have suffered from the volatility which grappled tech stocks in 2020 and 2021 when billions of dollars of market value were eroded when regulations viewed as abrupt by western standards were imposed.

Still, VWO remains a country-level diversified fund as shown above with a substantial exposure of 16% to India, which is benefiting from the heightened geopolitical tensions between the U.S. and China as seen with Apple's ( AAPL ) increased presence in the Indian subcontinent.

FRDM as an Alternative and Dollar Strength

Moreover, it pays quarterly distributions, which, as per my calculation, amounted to 4.1% last year based on the closing price on December 30, but for those who are not prepared to stomach the risks, the iShares Core MSCI Emerging Markets ETF ( IEMG ) with 28.17% of China exposure, could be suitable.

Still, for those who are now allergic to China, there is also the Freedom 100 Emerging Markets ETF ( FRDM ), a much smaller and more recently incepted fund by Alpha Architect with a higher expense ratio as shown in the comparison table below. It also offers a lower dividend but which is growing much more rapidly as seen by the three-year CAGR growth. On top, both FRDM's short and long-term price performances are superior and have suffered from less volatility.

Consequently, for those preferring fewer market disruptions and are ready to accept lower yields while dividends grow with time, FRDM offers a better option, but this thesis would not be complete if I do not cover the U.S. dollar, whose value has traditionally weighed on EM stocks.

Thus, the Federal Reserve's raising rates contributed to dollar strength in 2022 with the currency rising by more than 20% from March to November. Now, during the last year, the SPDR S&P 500 Trust ETF ( SPY ) lost 0.29% compared to 0.47% for FRDM, which is not a meaningful difference. Therefore, in view of China-related volatility, these two ETFs have delivered nearly the same performance despite the dollar appreciating significantly.

This is explained by the fact that after seeing the contagion effects of the GFC (Great Financial Crisis) on their economies in 2008, EM countries have taken measures to become more resilient, like removing firm dollar pegs and resorting to smarter funding methods involving less exposure to the greenback. Therefore, even if the U.S. Central Bank has to maintain rates higher for longer, resulting in sustained dollar strength EM economies should not be adversely impacted. Noteworthily, for countries that export to the U.S., the Fed is currently raising interest rates because the economy is stronger, not because of high global inflation as in 2022.

Investing in EM makes sense but Implies Risks

Therefore, for those wanting to diversify their investment away from developed markets, this is another reason to invest in EM this year. In addition, as I explained earlier, individual countries have taken measures to mitigate the appreciation of the dollar.

Also, by going through the holdings and country exposure, this thesis has shown that VWO has been more volatile and this could continue based on certain data-related restrictions unless you are based in China itself. There have been more recent curtailments on May 7, according to a report by Bloomberg. In this respect, while the country reopening its economy surely offers a lot of opportunities, it would be foolish to ignore the risks when investing your hard-earned money, before at least obtaining some clarifications from fund managers.

Instead, this thesis has identified an alternative in the form of FRDM for obtaining EM exposure, namely to countries that export commodities to China. This is synonymous with getting China exposure, but without necessarily bearing the risks due to rising geopolitical tensions with the U.S. Moreover, as a more actively managed fund, FRDM charges more, or 0.49%. As for the price action, from around $29.9 a share, I believe the ETF could rise to the $34.5 support level as the Fed gets toward the end of the current rate cycle in the second half of 2023.

Finally, given EM's past history of volatility which, in addition to economic-related woes, has also occurred as a result of country-specific events, investors should be prepared to digest a higher level of risks than for developed markets.

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