Emerging Markets and ETFs—A Good Idea?
A week-and-a-half ago, ACM’s portfolio managers had the pleasure of addressing a large audience at our annual due diligence conference. Representatives from a cross section of ACM’s distribution platforms were treated to the inside thought processes of the PM’s who manage the various products we deliver to clients (you!). During one question and answer session, my colleague David Ruff was asked a seemingly innocuous question: When is it a good idea to invest in Emerging Market ETFs (Exchange Traded Funds)? To most of the audience, the emphatic “Never!” was an answer they weren’t expecting.
“Never” is a bold statement and bears some backing up.
First, let’s distinguish between developed and emerging markets. Generally speaking, stock markets in developed countries are comprised of companies that obey the rule of law, follow regulations and usually try to create value and positive shareholder returns. That’s not to say there aren’t notable exceptions, of course—Enron springs to mind—but the general landscape is a capitalist-driven profit motive. Emerging markets frequently have a different agenda. Some resource rich countries have a sad history of treating their “geese that lay golden eggs” poorly. Look no further than Venezuela to see the country with the largest proven oil reserves in the world that has turned into a bankrupt basket case. Populism and habitually raiding the oil piggy bank created an economic disaster there. Even in cases not as extreme as Venezuela, many emerging markets, to various degrees, develop a political structure characterized by a ruling elite with a high concentration of power. The inevitable corruption all too often allows them to siphon off the nation’s wealth, effectively ruining the country’s business climate.
Even in countries that are not a purely extractive state, you can have a mix of private enterprise and state-owned entities (SOEs). In China, certain sectors, including energy, telecommunications, banking, and transportation are dominated by SOEs. The SOEs frequently have an agenda—or directive—inconsistent with a capitalist profit motive. Government directives are designed to carry out long-term, top-down driven strategies that give no credence to profitability or concern to minority shareholders. Not surprisingly, these are not the traits we look for in our portfolio holdings.
Let’s examine a few of the holdings in an EM ETF to see some real-life examples. We’ll use the iShares MSCI Emerging Markets ETF (ticker: EEM) as our test case. At first blush, the top 3 holdings are well known, globally recognized giants: Taiwan Semiconductor, Tencent, and Samsung Electronics. Two of these companies are holdings in ACM portfolios. Very soon after those, we start running into, shall we say, less than desirable holdings. China Construction Bank (10th biggest holding in EEM) is an SOE that flunks our corporate governance scoring criteria. Brazil’s Petrobras (21st biggest holding in EEM) suffers from the above-mentioned piggy-bank syndrome. Naspers (26th biggest holding) is a South African holding company whose value is driven by its 25% ownership stake in Tencent. Over the past 10 years, Naspers had traded at an NAV discount between -10% and -70%, averaging -34%. A value destructive holding is not what we look for in a company.
In the top 20 holdings of EEM are two Russian names. This is a problem. Russia’s invasion of Ukraine brought sanctions and retaliatory measures from Russia. It is currently illegal for foreigners to sell their Russian stocks. If you buy the EEM, you are buying stakes in (at least) two companies that are impossible to sell. This is not a dynamic we prefer to enter into.
The EEM holds more than 1200 securities. A quick scan of the smallest 300 are dominated by China-listed companies with an occasional Indonesian, Egyptian, Thai, Polish or Hong Kong name. We’re not saying that none of those companies could be good investments. We are saying that few, if any, would pass our corporate governance screening to allow them entry into our portfolios. Proper alignment between owners and management and fair treatment of minority shareholders is an absolute requirement of ours. In Emerging Markets, in particular, selection is crucial.
These examples are not exhaustive, merely instructive. When you buy an Emerging Market ETF, it’s not that you get the bad with the good, but you get some good, and a tremendous amount of bad. This is not to say that opportunity in EM doesn’t exist. It absolutely does.
ETFs certainly have their place, but to our mind, not in Emerging Markets. Thoughtful selection is critical when sifting through the thousands of publicly-traded EM companies. ACM’s international and global strategies bring that thoughtful selection to bear with the EM exposure in your portfolios.
Advisors Capital Management, LLC is an investment advisor registered with the United States Securities and Exchange Commission. Registration does not imply any degree of skill or training. All investing carries risk, including the potential for the loss of principal and past performance is no guarantee of future results. This content is for informational purposes only, can change at any time without notice, and is not investment advice or a recommendation to trade any security. Indices are not available for direct investment. We only provide services in jurisdictions where we are registered. Our disclosure brochure (ADV Part 2A) and customer relationship summary (ADV Part 3) are available at https://adviserinfo.sec.gov and upon request.
