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A Popular Emerging-Markets Consumer ETF Rocked By Currency Volatility

By Patricia Oey EGShares Emerging Markets Consumer (NYSEARCA: ECON ) has enjoyed strong inflows since its launch in 2010, thanks to its portfolio of high-quality consumer firms that have direct exposure to one of the main drivers of growth in the emerging markets: the rise of the middle class. This exchange-traded fund invests in 30 large-cap consumer companies domiciled in the emerging markets (which in this case excludes Taiwan and South Korea). Many of these companies, such as Brazilian brewer and soft drink company Ambev (NYSE: ABEV ) , Mexican convenience store operator and coke bottler FEMSA (NYSE: FMX ) , and Russian grocery chain Magnit, are well-run, market-dominating companies with industry-leading profit margins. Over the five-year period ended June 30, 2014, this fund’s index generated significantly higher annualized returns relative to the market-cap-weighted benchmark MSCI Emerging Markets Index (20.0% versus 9.2%) on slightly less volatility. This was because the weaker areas of the emerging markets, such as China large caps and commodity names, are not included in this consumer fund. However, while most of this fund’s constituents are high-quality companies, many are domiciled in countries that have experienced an uptick in currency volatility, especially over the second half of this year. Like most funds that invest in foreign equities, ECON does not hedge its foreign-currency exposure, so the returns of this fund reflect the change in the prices of individual securities as well as the change in the value of their respective local currencies versus the U.S. dollar. Relative to the MSCI Emerging Markets Index, this fund is heavy in countries such as South Africa (19% versus 8%), Brazil (15% versus 11%), and Chile (7% versus 2%). All of these countries have recently experienced sharp declines in the value of their currencies against the U.S. dollar. This is attributable, in large part, to falling commodity prices. Commodities comprise a significant portion of each of these countries’ exports. In South Africa, miner strikes over the past few years have weighed on commodity exports. More recently, power outages, which have an impact on all business sectors, are further exacerbating the nation’s current accounts deficit. In Brazil, the economy remains weak and there is uncertainty regarding the policies of new finance minister Joaquim Levy. While Levy has promised to impose more fiscal discipline, he will face many challenges given the Brazilian economy’s numerous structural issues. As for Chile, this copper-rich country is still struggling from the fallout of the commodity bubble. In the near term, it is likely the economies of these countries will remain weak, which may result in more currency volatility. Fundamental View The investment thesis for this fund is a logical one: Emerging-markets consumers increasingly are reaching middle-class status and have more disposable income to spend on items from cars and electronics to packaged foods and beverages. Other growth drivers include the rise of consumer credit, urbanization, and relatively young populations in a number of emerging markets. Personal incomes are growing rapidly as well. According to the International Labour Organization, from 2000 to 2010, real wages rose 86% and 13% in Asia and Latin America, respectively. This compares with 6% real wage growth in the developed economies over this same span. The rapid growth in Asia was driven primarily by China, where real average wages have more than tripled over that period. This fund’s Mexican holdings, which account for about 16% of its portfolio, include companies such as FEMSA and Grupo Televisa (NYSE: TV ) . These companies are highly profitable, have durable competitive advantages, and possess the economies of scale needed to service regional markets. Mexico’s current leadership is working on a reform program to address long-standing issues such as inefficiencies in the labor market, underinvestment in the state-owned energy sector, and the government’s dependence on oil revenue–all of which may help unlock Mexico’s growth potential and drive growth for this fund’s Mexican holdings. ECON is trading at 24 times trailing 12-month earnings, a significant premium to the MSCI Emerging Markets Index’s 13 times trailing 12-month earnings. This is partly attributable to a higher earnings outlook for ECON’s holdings relative to the MSCI benchmark’s holdings. There is also strong investor demand for the firms in ECON’s portfolio, as there are relatively fewer consumer names in emerging markets–consumer companies account for about 17% of the MSCI Emerging Markets Index, which is lower than their 23% weighting in the S&P 500. However, while ECON’s price/earnings premium over the MSCI Emerging Markets Index has widened over the past three years, ECON’s P/E premium versus an index of global consumer firms and U.S. consumer firms has been relatively steady over the same time period, which suggests that ECON’s current valuations are not expensive relative to its global consumer peers, although consumer firms as a group are a little pricey–they are trading at P/E multiples slightly higher than their 10-year average. Portfolio Construction This ETF tracks the Dow Jones Emerging Markets Consumer Titans Index, which is a modified market-cap-weighted index that includes 30 leading emerging-markets companies that are in the consumer goods and consumer services industries. Since its inception, ECON’s portfolio has had low turnover. However, following its annual rebalance in September 2013, ECON’s weighting in Chinese companies rose to 16% from 6% because of a change in classification of Chinese p-chips (non-government-controlled Chinese companies listed in Hong Kong) from Hong Kong companies to Chinese companies. New additions include two companies with Narrow Morningstar Economic Moat Ratings–Hengan International (a personal-care products company) and Belle International (a footwear manufacturer and sportswear retailer)–along with unrated Want Want China (a snack food company) and China Mengniu Dairy. ECON’s larger China allocation came primarily at the expense of its India allocation, which fell to 7% from 10% after this year’s reconstitution. South African media firm Naspers (ECON’s largest holding at 10%) also can be considered a China play. It has a 34% stake in the China Internet company Tencent Holdings, and this represents a significant portion of Naspers’ market value. Fees This ETF’s 0.84% expense ratio makes it one of the most expensive emerging-markets ETFs. Alternatives ECON’s portfolio has better exposure to emerging-markets consumption trends relative to other similar choices. IShares MSCI Emerging Markets Consumer Discretionary (NASDAQ: EMDI ) has a heavy 30% weighting in South Korean auto and consumer electronics companies; these firms serve the global marketplace and have relatively lower exposure to the emerging-markets consumer. Also, EMDI, by design, invests only in consumer discretionary firms, whereas ECON has about a 50/50 exposure to consumer discretionary and consumer staples firms, making ECON less volatile. The other option is WisdomTree Emerging Markets Consumer Growth (NASDAQ: EMCG ) , which launched in September 2013. This fund is slightly different in that it has a 60% allocation in consumer firms and a 40% allocation in firms likely to benefit from consumer spending, primarily banks and telecoms. EMCG also screens for companies with relatively stronger earnings growth outlook, higher historical returns, and lower valuations. The fact that this fund employs numerous quantitative screens makes it difficult to predict how much the portfolio may change during its annual reconstitution. We recommend investors monitor EMCG’s live performance for at least a year before considering this fund. 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.