Opportunity Beckons With Emerging Markets ETFs

Rebounding emerging markets equities and exchange-traded funds are one of this year's most compelling investment stories. So compelling is the emerging markets rally that investors are piling back into the very ETFs they could not wait to abandon.

At least three factors – the weaker dollar, rebounding commodities prices and China's economic recovery – have some market observers waxing bullish about developing world stocks and ETFs.

“The Federal Reserve (Fed) has signaled it is set to keep rates on hold for now. This has lowered the near-term risk of EM capital outflows, weakened the U.S. dollar and boosted oversold EM currencies. Also supporting EMs: firming oil prices, fading global recession fears and signs China’s economy may enjoy a cyclical rebound,” said BlackRock, the world's largest asset manager and ETF issuer, in a recent note.

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Emerging Markets ETFs

Year-to-date, the Vanguard FTSE Emerging Markets Stock Index Fd VWO and the iShares MSCI Emerging Markets Indx (ETF) EEM, the two largest emerging markets ETFs, are up an average of 6.5 percent. Neither of those funds have finished higher on an annual basis since 2012.

However, investors have not been shy about betting that 2016 ends emerging markets ETFs' losing streak. At least that what flows data are saying.

Flows Data

“This 'sweet' economic backdrop helps explain an EM rebound, evident in EM-related exchange traded products (ETPs) attracting nearly $16 billion this year, according to BlackRock research. EM ETPs have recouped 75 percent of 2015 outflows, the ‘short EM’ trade is much less crowded than it was at the start of the year, and EM valuations are no longer unambiguously cheap, our research suggests,” said BlackRock.

That, after EEM and VWO lost over $9.4 billion combined last year and about $4.7 billion in 2014. On its own, EEM added $4.6 billion in new assets last month.

Emerging Markets Bond ETFs

Emerging markets bond ETFs, such as the PowerShares Emerging Markets Sovereign Debt Portfolio PCY are also benefiting from the Fed's reluctance to boost interest rates.

Emerging markets governments and some corporations binge borrowed in dollars during the various versions of the Fed's quantitative easing programs. It looked smart as the dollar weakened against a plethora of developed and emerging currencies, but those emerging markets borrowers were caught off guard when the dollar started soaring several years ago.

PCY has added $317.3 million in new assets this year, a total exceeded by just three other PowerShares ETFs.

“Fed tightening, a Chinese yuan devaluation or economic slowdown, and a renewed slump in oil prices are all risks to the EM story. We see the Fed remaining dovish through mid-year. Yet risks could return in the second half as U.S. rates increase and China’s credit-fueled growth improvement slows,” cautioned BlackRock.

Disclosure: Todd Shriber owns shares of VWO.