By
Morningstar
:
By Patricia Oey
WisdomTree Emerging Markets Equity Income ETF (
DEM
) has long been our favorite exchange-traded fund for
emerging-markets equity exposure, thanks to its significantly lower
volatility relative to the MSCI Emerging Markets Index and stellar
trailing five-year risk-adjusted returns. Unlike most passive funds
that track a market-cap-weighted index, DEM tracks a
dividend-weighted index. Once a year on May 31, the fund rebalances
its portfolio, using total dividends paid by the firms in its
investable universe over the past year to inform its position
weightings. Last year's rebalance resulted in some significant
changes to the fund's profile, and we think DEM may be a more risky
fund in the near term, relative to its recent history.
DEM's Methodology
Most dividend funds weight their holdings by stocks' dividend
yield, but DEM's methodology is different. At the May 31 rebalance,
DEM's benchmark index screens the universe of emerging-markets
stocks for firms that have paid out at least $5 million in regular
cash dividends over the past 12 months and have met certain
market-cap and liquidity requirements. These companies are then
ranked by dividend yield, and the top 30% are selected for
inclusion in DEM's index. Constituents are weighted by dividends
paid, measured by trailing 12 months dividends per share multiplied
by shares outstanding, converted into U.S. dollars. This
methodology attempts to create a relatively high-yielding fund with
a large-cap tilt (larger companies tend to pay a higher total
amount of dividends) and a slight value tilt. (At the rebalance,
the index tends to sell lower yielding companies and buy
higher-yielding companies).
There are interesting intricacies to this WisdomTree dividend
strategy, especially when applied to the emerging markets, which is
a very diverse universe. For example, Taiwanese and Brazilian
companies tend to be higher dividend payers due to tax rules and
laws that support dividend payouts. As a result, emerging-markets
dividend funds, including DEM, tend to have substantial exposure to
these countries. In addition, governments can influence company
dividend policies, and in turn, the composition of this fund.
Finally, because DEM's positions are weighted by dividends paid,
measured in U.S. dollars, the portfolio can also be affected by
currency movements.
From Russia With Love?
The most notable change to DEM's portfolio resulting from the 2012
rebalance was the large increase in exposure to Russian stocks,
which went from a low-single-digit percentage over the past few
years to 13%. This represents a significant overweighting relative
to the MSCI Emerging Markets Index's 6% weighting in Russia. While
Russia is currently trading at cheap valuations (the MSCI Russia
Index is trading at about 5 times trailing 12-month earnings versus
a five-year average of 7 times), investing in Russia is a very
risky proposition--the country's stock market has very heavy
exposure to the energy sector, the ruble is extremely volatile, and
corruption within Russia is rampant. Since DEM's inception in 2007,
most Russian firms have failed to qualify for inclusion in DEM's
benchmark index. However, at the 2012 rebalance, shares of
state-owned natural gas monopoly Gazprom (GZPFY.PK) were added for
the first time. Gazprom stock now accounts for a significant 7% of
the portfolio after the firm more than doubled its dividend
payout.
Gazprom's hand was forced by a new rule requiring
government-owned firms to pay out at least 25% of their net profits
as dividends. While the government has stated that it hopes this
change will attract more investment into Russia, the state also
benefits as a majority shareholder in these companies. If this
mandate remains in place, more state-owned firms may be added to
DEM. This can be a source of risk, as state-owned Russian firms,
and particularly those in the energy sector, can operate at the
behest of the government to support national economic goals or the
federal budget (through higher taxes) at the expense of
profitability.
Banking on China
DEM's exposure to China also spiked following last May's
rebalancing, from about 4% over the previous two years to the
current 16%. The largest additions to the portfolio were China
Construction Bank (CICHY.PK) (now at 8%) and Industrial and
Commercial Bank of China (now at 3%). These two firms, along with
Bank of China (BACHY.PK) (which was not a new addition) are all
state-owned banks and together account for more than 13% of DEM's
portfolio. These banks have paid out relatively stable dividends
over the past few years. But at the time of the 2012 rebalancing,
these firms' stocks were trading near multiyear lows, largely
because of concerns about their exposure to bad loans related to
the 2009 stimulus program and a deflating housing bubble. Thanks to
weak share prices, these firms were sporting mid-single-digit
dividend yields, which qualified them for inclusion in DEM's
benchmark index. While these banks are mega-cap companies, their
combined 13% weighting in DEM is significantly higher than their 3%
weighting in the MSCI Emerging Markets Index. This can be partly
attributed to currency effects. The yuan was the only currency (out
of all of DEM's major underlying currency exposures) to appreciate
relative to the U.S. dollar in the 12 months leading up to May 31,
2012. Because constituents are weighed by total dividends paid,
expressed in U.S. dollars, these Chinese firms received a further
boost in their relative weighting given the yuan's strong
performance relative to other emerging-markets currencies in the
run-up to the rebalancing.
These three Chinese banks' stocks have rallied from 20% to 30%
since they have been added to DEM. If they continue their strong
performance, it is possible their dividend yields will fall to the
point that they will no longer qualify for index inclusion come
this year's rebalance--a perfect example of the buy low, sell high
mechanism embedded in the underlying index's methodology. Should
they remain in the portfolio come the end of May, it is clear that
they face a number of risks. They are still exposed to the
potential of souring loan portfolios and may need to trim dividends
to strengthen their balance sheets, which would negatively affect
share prices. The government also plans to liberalize interest
rates in an effort to stimulate competition. Such moves could
threaten these banks' highly profitable oligopoly. And like
Gazprom, these banks can be called upon to "support" government
initiatives as they have in the past, putting the interests of
Beijing ahead of profitability.
A Carnival of Dividends in Brazil
In Brazil, regulators require companies to pay out a minimum of 25%
of net earnings to shareholders. As a result, Brazilian companies
tend to be higher dividend payers relative to many other
emerging-markets companies. Over the past two years until the 2012
rebalance, Brazilian stocks accounted for about 20% of DEM's
portfolio. But after last year's rebalance, Brazil's representation
in DEM's portfolio fell to 14%, primarily due to currency effects.
In the 12 months leading up the 2012 rebalance, the Brazilian real
suffered the greatest decline versus the U.S. dollar among the
local currencies of all of DEM's top country holdings. The real's
decline was a factor of weak economic growth and continued
government intervention in the currency market. Again it's
important to remember that currency fluctuations can have an impact
on the composition of DEM's portfolio.
Dialing Down Risk
DEM's trailing five-year standard deviation was 24% as of December
2012, which was significantly lower than the MSCI Emerging Markets
Index's 29%. DEM's five-year upside capture ratio (using the MSCI
EAFE Index as a benchmark) of 105 was lower than the MSCI Emerging
Markets Index's 119. However, its downside capture ratio was
significantly lower (79) than that for the MSCI Emerging Markets
Index (108). While avoiding large drawdowns is very important for
the long-term performance of emerging-market funds, a less volatile
fund may also help improve an investor's experience, as investors
tend to sell funds as they fall. While we think DEM's volatility
will remain below that of the MSCI Index, we are concerned about
these potentially higher-risk China and Russia holdings, and the
fact that DEM's exposures in China and Russia are not diversified.
In the seven months since the 2012 rebalance, we note that the
volatility gap between DEM and the MSCI Emerging Markets Index has
narrowed.
Other emerging-markets equity
ETFs
that offer lower volatility relative to the MSCI Emerging Markets
Index include iShares MSCI Emerging Markets Low Volatility (
EEMV
) and EGShares Emerging Markets Consumer (
ECON
). EEMV holds a portfolio of stocks culled from the MSCI Emerging
Market Index that has the lowest absolute volatility, subject to a
set of constraints to maintain diversification. Over the past 10
years, this index has provided an average of 400 basis points per
year of excess return relative to its parent index, while
exhibiting much lower volatility. This fund charges a relatively
low 0.25% annual expense ratio. As for ECON, while sector equity
funds tend to be more volatile than the broad market, this fund's
lower volatility stems for the fact that it invests in the 30
largest emerging-markets consumer companies, many of which are
highly profitable firms that dominate their respective markets.
This ETF charges an annual expense ratio of 0.85%.
Disclosure:
Morningstar, Inc. licenses its indexes to institutions for a
variety of reasons, including the creation of investment products
and the benchmarking of existing products. When licensing indexes
for the creation or benchmarking of investment products,
Morningstar receives fees that are mainly based on fund assets
under management. As of Sept. 30, 2012, AlphaPro Management,
BlackRock Asset Management, First Asset, First Trust, Invesco,
Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or
more Morningstar indexes for this purpose. These investment
products are not sponsored, issued, marketed, or sold by
Morningstar. Morningstar does not make any representation regarding
the advisability of investing in any investment product based on or
benchmarked against a Morningstar index.
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