Why Have Emerging Market Income ETFs Underperformed?
Rock-bottom interest rates have created a challenging environment for investors eyeing a decent and fairly reliable income stream. Many investors are turning towards dividend-oriented strategies to compensate for the low yields bonds offer.
Aside from providing investors with income, dividend paying companies tend to have stronger corporate governance structures in place. As such, dividend equity funds often provide access to better quality holdings, but this is not always the case.
While many investors associate stable equity dividends solely with developed economies, the concept is also applicable to emerging markets. And exchange-traded funds have facilitated access to that asset class.
Yield and Total Return: How They have Performed
Emerging markets equity funds have been down for three consecutive calendar years. The MSCI Emerging Markets Index in U.S. dollar terms has declined 14.72% on an annualised basis, over the past three years through May 2016. By contrast, the MSCI World; the benchmark of reference for global developed markets, grew by 19.06%.
Looking forward, the International Monetary Fund projects that global growth will remain muted amid China’s economic slowdown, deeper than expected downturns in Brazil and Russia, and continuing commodity headwinds. Historically speaking, during economic downturns, investors flock to risk reducing or quality screened strategies, which tend to outperform the general market during more bearish climates.
Generally, dividends are associated with defensive characteristics. Most firms in traditionally defensive sectors of the economy; utilities, telecoms, healthcare, and consumer staples, tend to provide above average dividend yields, as well as a smoother ride through cyclical swings in the economy. This makes such stocks easier to hold through bouts of uncertainty.
And in fact, the data shows that during what has been a bad period overall for the asset class, emerging markets dividend funds have delivered higher yields than their market-cap weighted cohorts.
On average, the three ETFs have managed to pay around 4%-6% in annual dividend yields over the past three years. By comparison, dividend yields for average market-cap weighted emerging markets ETFs have been lower, at around 2%.
However, in total return terms, all three dividend-oriented emerging-markets ETFs underperformed the MSCI Emerging Markets Index since their respective inceptions, mostly because of their country tilts, which were not best suited for recent market conditions, namely falling oil prices.
These are iShares Emerging Markets Dividend ETF (IEDY), WisdomTree Emerging Markets Equity Income ETF (DEMD), and SPDR S&P Emerging Markets Dividend ETF (EDVD).
The extent of underperformance varies among the three ETFs, given each fund tracks a different index. First, dividend-oriented emerging-markets ETFs had overweights in commodity exporting countries.
For example, countries like Brazil, South Africa and Russia have laws supporting higher dividend pay-out ratios, and as a result companies in these countries pay higher dividends. Meanwhile, companies in countries like India tend to reinvest capital to fuel growth, instead of paying dividends.
Second, emerging markets funds were punished by negative currency translation effects. The Brazilian real, the Russian ruble and the South African rand declined by 40% to 50% against the U.S. dollar during the past three years.
Over the same period, the MSCI Emerging Markets Index in U.S. dollars terms declined 14.72% but rose 3.83% in local currencies. With the Fed’s softer stance on interest rates and a stabilisation in commodity prices, emerging markets ETFs have recently started to rebound. But investors considering a dividend-oriented emerging markets fund need to carefully examine the screening criteria of its underlying index to better understand the various biases and possible risks involved with owning such a fund.
On the whole, dividend-oriented emerging markets ETFs have lagged their market cap weighted emerging markets counterparts in recent years. But in all fairness, these strategies may have been launched during their worst possible days, and, by discarding them completely, we may be committing a serious case of time period bias.
All in all, the outlook for emerging markets remains murky, but with commodity prices and currency markets slowly stabilising, these strategies are regaining traction. For now, it’s too early to tell.
Source Morningstar – Monika Dutt | 07/07/2016