Betting on Consumers in Emerging Markets, London Firm Takes New Approach to ETFs

By  JAN 18, 2013 12:33 PM

Generation Asset Management uses a unique, systematic approach to investing in the developing world with the objective being superior risk-adjusted returns.


Editor's Note: This content was originally published on by The ETF Professor.

In the ever-expanding world of emerging markets ETFs, some diversified funds still sit atop this corner of the exchange-traded products universe. For example, the Vanguard FTSE Emerging Markets Index (NYSEARCA:VWO) and the iShares MSCI Emerging Markets Index Fund (NYSEARCA:EEM) remain favorites of investors – both professional and retail.

Some investors choose to use an ETF such as EEM and VWO as their sole avenue for exposure to the developing world, but there are plenty of other worthy options when it comes to multi-country emerging markets funds.

In fact, one London-based asset manager is proving it is possible to use the likes of EEM, VWO, and related fare simultaneously, in one portfolio, to deliver impressive risk-adjusted returns. Generation Asset Management, a unit of Canadian hedge fund giant Arrow Capital Management, uses a unique, systematic approach to investing in the developing world with the objective being superior risk-adjusted returns in what is often viewed as a volatile asset class.

Generation Asset's model portfolio rebalances on a weekly basis and is 50% benchmarked to the MSCI Emerging Markets Index and 50% to JPMorgan EMBI Global Core Index. That means the model features both equity and bond ETFs.

In addition to VWO, which currently represents about 25% of the model portfolio's equity-based weight, Generation Asset is using other, less heralded emerging markets ETFs such as the EGShares Emerging Markets Consumer ETF (NYSEARCA:ECON). ECON is heavy on local brands that emerging markets consumers are most familiar with, not multinational brands that only derive a sliver of their total sales from the developing world.

"We strongly believe in the EM consumer story," said Generation Asset analyst Bartlomiej Fraszczyk. Emerging market consumers do most of their business with familiar local or regional brands, and tend to have less affinity for developed world brands. We believe domestic demand will be the main driver of EM economies growth."

Fraszczyk said Generation Asset views ECON's country weights in a favorable light. South Africa, Mexico, and Brazil combine for over 54% of the ETF's weight. Malaysia receives an allocation of 6.25%.

"Our observation is that over the period of the last three years, South Africa, Mexico, and Malaysia have consistently outperformed the MSCI EM Index," noted Fraszczyk. "We also like Brazil, India, and Chile as they display unique consumer growth themes. The point is, the ECON provides us with a perfect country allocation split."

Betting on Dividends, Damping Volatility A cornerstone of Generation Asset's rules-based model is capturing dividends while mitigating volatility. The dividend portion of the firm's model portfolio centers around the rapidly growing WisdomTree Emerging Markets Income Fund (NYSEARCA:DEM) and DEM's small-cap equivalent, the WisdomTree Emerging Markets SmallCap Dividend Fund (NYSEARCA:DGS).

"We like the fact that these ETFs are sizeable in terms of assets and offer good liquidity," said Fraszczyk. "We value the WisdomTree research development work and new products creation innovation. We have seen those two ETFs being successful so far and we believe the dividend space will continue to grow in 2013." DGS currently sports a 30-day SEC yield of 4.17%. Taiwan, Thailand, and South Korea combine for almost 44% of that fund's country weight. DEM has a 30-day SEC yield of 3.87%. Taiwan, China, Russia, and Brazil loom large in DEM, combing for over 51% of that ETF's weight.

When it comes to damping out emerging markets volatility, a theme that soared to the front of the ETF lexicon in 2012, Generation Asset prefers the $915.6 million iShares MSCI Emerging Markets Minimum Volatility Index Fund (NYSEARCA:EEMV).

With lower volatility relative to the MSCI Emerging Markets Index, EEMV has easily outpaced EEM and VWO over the past year. Fraszczyk does not foresee ETFs such as EEMV overshadowing flagship funds such as EEM and VWO, but he likes EEMV's utility in limiting the model's downside equity risk while delivering alpha.

EEMV's ability to skirt volatility comes almost as much by way of what countries are excluded from the ETF as what markets the fund does offer exposure. Prominent allocations to Taiwan, China and South Korea are arguably not surprising. However, the fund features no exposure to India and Russia represents less than one percent of EEMV's weight.

Another Prominent Theme Due to reduced correlations to US equities, improving credit ratings and sturdy government balance sheets in many developing markets, emerging markets bond ETFs soared last year, both in terms of assets gained and delivered returns.

Generation Asset's emerging markets fixed income holdings are the iShares JPMorgan USD Emerging Markets Bond Fund (NYSEARCA:EMB) and the PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEARCA:PCY). Fraszczyk sees both EMB and PCY as currently being in strong uptrends. It is hard to argue with that assessment as EMB is up 17.1% in the past year while PCY has surged almost 22%.

Investors continue to pour cash into these products. In just over two months, EMB has seen its assets under management grow to $7 billion from $6.2 billion. PCY had $2.5 billion in AUM in early November, but that number was almost $3.1 billion as of January 18.

On the surface, it may appear that owning both EMB and PCY is duplicative, but these funds have noticeable differences at the country level. For example, EMB's top-five country weights are Brazil, Russia, Turkey, Mexico, and the Philippines. PCY's are Turkey, Croatia, Romania, Hungary, and Lithuania.

Generation Asset's current preference is for dollar-denominated emerging markets debt. However, the firm's model, which can be transposed across myriad regions with sufficient liquidity, can be custom-tailored to give clients exposure to local currency emerging markets bonds.

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