Why Emerging Markets ETFs Don’t Work

Why Emerging Markets ETFs Don’t Work

A Threat to Our Very Way of Life

Giant E-Commerce Stock

Emerging markets ETFs, the strategy that doesn’t really deliver results.

I’m going to make a blunt statement, which is always risky. But hear me out, because what I have to say has direct effects on your financial success.

When it comes to emerging markets stocks, the strategy employed by many financial advisors is not working to your advantage. That’s because financial advisors are, generally speaking, all about risk control. Risk control explains why advisors are reluctant to put their clients into individual stocks, preferring the lower volatility of index funds and sector ETFs. It’s also why they want to move assets away from all equity exposure as their clients approach retirement age, looking toward the safety and predictability of fixed income bonds.

I can understand the reasoning behind such a strategy. The distress many investors feel from any decline in the value of their assets is much greater than the satisfaction they experience when their assets appreciate. So avoiding losses is (for the financial advisor) an overriding concern.

From my perspective as someone who advises people on how to invest in emerging markets equities, there are a couple of problems with this kind of thinking.

First, as the bursting of the two major bubbles of the 21st Century has shown, even “low-risk” diversification of equity exposure via index funds can be overwhelmed by “once in a lifetime” events, especially when they occur twice in a decade.

Second, moving assets into low-risk bonds ignores the reality that bond yields have been suicidally low since 2009, and could remain low for years. Having a large allocation to bonds is tantamount to letting mice into your corn crib. Inflation will reduce your buying power faster than the pitiful interest rate will increase it.

An advisor who follows the common wisdom and allocates 10% of a client’s portfolio to emerging markets equities will likely be petrified by the volatility of the individual stocks that are available for developed-country investors to buy. And he will seek a lower-risk proxy for such exposure, probably in a regional, country or sector ETF.

One common choice for those interested in the burgeoning economy of China, the driving force behind all emerging markets ETFs, is the PowerShares Golden Dragon Halter USX China ETF (PGJ). The Golden Dragon tracks the collective performance of all Chinese stocks that trade on U.S. exchanges as ADRs (American Depositary Receipts, which are dollar-denominated securities that represent multiple native Chinese stocks).

The crucial factor in using an ETF like Golden Dragon is that averaging the worst China ADRs along with the best of them can produce distinctly unimpressive results. Here’s a one-year chart showing the performance of PGJ from November 19, 2013 through today. This chart shows lots of movement, but little progress.

(Note: Yes, this is a cherry-picked chart. Below is a full two-year chart that shows the great 2013 rally. But the fact remains that an ETF like Golden Dragon can tread water for a year even as individual Chinese stocks are making strong moves.)

The full two-year chart for Baidu (BIDU), for instance (below), shows the stock’s ability to power past slack times in PGJ.

And below is the two-year chart for Vipshop Holdings (VIPS), a leading Chinese online retailer that specializes in flash sales.

I don’t contend that investment advisors should ditch their conservative, risk-averse dependence on diversification. But I do believe that a strategy that uses the flexibility individual investors have in their portfolios to 1) enter emerging markets when the momentum is positive, and 2) seek out strong individual stocks in uptrends, can produce much better results with controllable risk.

This strategy has been followed by Cabot China & Emerging Markets Report for more than a decade with excellent results. Cabot China is currently rated #6 by Hulbert Financial Digest for one-year performance.

When Chinese ADRs are doing well, Cabot China & Emerging Markets Report will do very well. And when Chinese ADRs are in a slump, the Report’s subscribers will be advised to exit the market and go to cash. It’s a winning strategy that has distinct advantages over seeking exposure through broad indexes and ETFs.

There’s never any shortage of scary stories on the Web.

Investors are always hearing about the coming crisis that will burn through equity markets like the Chicago fire, reducing everyone’s retirement account to ruins. (It’s probably just a coincidence that the person who wrote that article has a financial survival strategy that they will sell you for a reasonable sum. Now that I think about it, most of the dire predictions on the Intertubes come with such an offer. Hmmmm. It’s almost enough to make you suspicious.)

As a rule, I discount any and all such warnings. They fade into the background noise of the equity world along with the equally strident warnings that I’m going to miss the greatest opportunity in the history of the world unless I buy some penny stock that’s “poised for enormous gains!”

But every once in a while, I read a warning that really hits me where I live. And in the past week, I’ve read two of them. Read on for details … IF YOU DARE!

The first big warning was from the annual reports of a couple of international confectioners, privately held Mars and Barry Callebaut. Each of these companies let it be known that they anticipate a shortage of cocoa in the years ahead, with Callebaut setting the potential shortfall at a million tons of cocoa by the year 2020.

There are several reasons for this disturbing threat, including a developing Chinese taste for chocolate, which opens up a huge market that hasn’t previously been interested. The other reason is a fungus called “frosty pod” that’s ruined between 30 and 40 percent of the world’s cocoa production.

As someone who regards chocolate as a vital health food and a basic requirement for civilized existence, I’m a little on edge about this.

The other horrifying story is the recent notification by Buffalo Trace Distillery that the supply of bourbon would fall far short of demand, raising prices and causing shortages. If, like me, you strongly prefer your glass to be filled with amber liquids rather than clear liquids, this is another shock to the foundation.

The group issuing the bourbon warning points out that all bourbon, even the cheap stuff, must be matured in new oak barrels for a period of years, with barrels losing up to half their contents during the process. Premium brands-the kind that one reserves for especially rewarding times-may be aged for over 20 years.

Certainly I’m in sympathy with the plight of distillers who must sit on their aging assets for a decade or two before delivering it to me.

But if rising global demand causes a genuine shortage, I’m going to be quite peeved.

Truly, the modern world poses daunting threats to our very way of life.

My stock pick today is one that I’ve talked about before. It’s Alibaba (BABA), the giant Chinese ecommerce company that came public just two months ago. I recommended it to my subscribers during the first week of November.

I was pleased to see BABA show up in Cabot Top Ten Trader, our weekly publication that features the ten strongest stocks of the previous week. Here’s what the description of BABA’s strength in Cabot Top Ten Trader had to say on November 10.

“Alibaba is the world’s largest e-commerce company, and is based in China, which is the world’s fastest-growing e-commerce market. The company operates many separate divisions, each with its own website, and is constantly expanding into new lines of business. Taobao Marketplace is the company’s biggest site, a place for seven million merchants to sell everything in the world. Listing on Taobao is free, but sellers who want to stand out can buy ads to improve their visibility. Tmall is Alibaba’s third-party platform for top quality branded merchandise. Alibaba.com is a global wholesale platform that lets small manufacturers sell to foreign customers. Ali Express is a global retail marketplace aimed at shoppers outside China, offering direct sales from Chinese wholesalers and manufacturers. Alibaba also has Alipay, an online payment system similar to PayPal. Like Amazon, Alibaba has grown revenue quickly, with fiscal 2014 growth at 56%. Unlike Amazon, Alibaba has been consistently profitable, without a loss in years. EPS is forecast to grow from $1.83 in fiscal 2014 to an estimated $2.22 in 2015 and $3.02 in 2016. With a huge war chest from its stunning IPO, the company has the capital to expand in as many directions as it wants. In its first quarterly report since coming public, Alibaba revealed 53% revenue growth, with plenty of growth from mobile devices. At this point, Alibaba hasn’t put its foot wrong with investors and with Singles Day coming up tomorrow (the largest shopping day of the year in China), the future looks rosy.”

By the way, Alibaba delivered a massive $9.3 billion in sales on Singles Day, which is greater than the entire market caps of some substantial U.S. businesses. BABA has been digesting its early November gains over the past week, slipping from around 120 last Thursday to around 112 today. That’s a normal correction for a stock that’s as much in the public eye as Alibaba’s. I think BABA is buyable here and has huge potential. You can use a mental stop at 103, just a hair above the stock’s rising 25-day moving average.

For more updates on BABA and an additional 10 momentum stocks each week, take a risk-free subscription to Cabot Top Ten Trader. This year, we grabbed many double and triple-digit winners, including 303% gains in Vipshop Holdings, 126% gains in Canadian Solar and 133% gains in Netflix, and we see many more strong stocks that have the possibility to be the next year’s winners.


Paul Goodwin 

Chief Analyst, Cabot China & Emerging Markets Report
Editor of Cabot Wealth Advisory

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