SCHE: Seeking Opportunity In Emerging Markets

(This article was co-produced with Hoya Capital Real Estate.)

It’s almost an understatement to say that 2022 has been a rough year for emerging markets.

Many of these countries have been extremely hard-hit by the COVID-19 pandemic, and the latest round with Omicron hasn’t done them any favors. Compounding this has been Russia’s invasion of Ukraine.

At the same time, a few glimmers of hope have emerged. Overall GDP growth in 2021 came in slightly higher than expected. In a recent outlook, S&P Global reports that overall real GDP growth in 2021 now appears to have been 7.3% for its sample of 16 EM countries, 0.3% higher than was expected in November. Excluding China and India, EMs likely grew 5.6% during the year, materially above S&P’s 5.0% forecast.

Emerging Markets – Challenges and Opportunities

At the same time, challenges definitely remain. From that same report, here’s a summary box synopsizing key elements of the picture ahead.

For investors looking at emerging markets, the above information provides good reason for concern. At the same time, might these concerns lead to opportunity?

In the above information, reference was made to how things have played out in emerging markets compared to the outlook as of November 2021. How has this been reflected in the performance of related equities?

Our featured ETF in this article is Schwab Emerging Markets Equity ETF (NYSEARCA:SCHE). Let’s use this ETF, compared against SPY, as a quick proxy for how emerging market equities have performed against their U.S. counterparts.

As can be seen, from a timing standpoint, the difference has been stark since February 24, the very point that Russia invaded Ukraine. The last paragraph in the above-referenced summary box from S&P Global nicely summarizes the challenges, and fears, specifically related to this event.

What, though, might be the opportunities? Perhaps this next graphic, from a recent report from Yardeni Research, can shed some light on this.

In general, emerging markets hold potential for greater long-term growth than do more developed markets. In the above graphic, it becomes clear that investors may be able to tap into that potential at a good price. Clearly, at a forward P/E of 19.6, the U.S. market is the most expensive option. The entire world comes in at 16.4. If one looks to the EAFE countries, representing the developed world ex-U.S., we find the ratio coming in at 13.4. At a forward P/E of 11.6, emerging markets are priced at roughly 60% of the U.S. market.

Clearly then, particularly for investors with a longer-term time horizon, there appear to be opportunities here. Further, given that 10% deficit in performance over the last 6 months compared to U.S. stocks, there might even be the possibility of a nice short-term play.

With that background, let’s take a closer look at our featured ETF. Along the way, we will also take a quick look at two of SCHE’s competitors, and see what conclusions can be drawn.

Schwab Emerging Markets Equity ETF – Digging In

With an inception date of 1/14/2010, SCHE has established a solid track record. It currently has Assets Under Management (AUM) of $9.070 billion. It sports a low .11% expense ratio, and shares are traded actively enough that it manages a trading spread of .04%. Considering the expenses associated with tracking emerging market equities, these are decent numbers. However, as we will see a little later, some of SCHE’s competitors do even better.

How does SCHE accomplish all of this? Here is a quick overview, from the fund’s summary prospectus:

To pursue its goal, the fund generally invests in stocks that are included in the FTSE Emerging Index. The index is comprised of large and mid capitalization companies in emerging market countries, as defined by the index provider. The index defines the large and mid capitalization universe as approximately the top 90% of the eligible universe. As of August 31, 2021, the index was composed of 1,850 stocks in 23 emerging market countries.

You may have caught a couple of details. First of all, SCHE focuses on the large- and mid-cap range of the spectrum. Still, this encompasses roughly 90% of the eligible universe.

In that same prospectus, Schwab notes that, under normal circumstances, the fund may invest up to 10% to its net assets in securities not in the index. Among other reasons, this allows fund managers to anticipate securities that may either be added to, or removed from, the index. The fund also makes use of sampling techniques to replicate the index as closely as possible without having to incur the expense of being forced to trade every security in the index.

Finally, the prospectus notes that the fund may use futures contracts and other derivatives to seek returns on otherwise uninvested cash to help it better track the index.

With that said, let’s take a closer look at some specifics. In its fact sheet for SCHE, Schwab includes a ton of helpful information in this comprehensive graphic.

I’ll just point out a couple of key items to note. On the positive side, and in conjunction with the graphics featured in the first section of the article, note that low 12.72 P/E ratio.

Here is one potential drawback to keep an eye on. The portfolio weights holdings by market cap. Because, as featured earlier, SCHE focuses on large- and mid-cap equities, this tends to heavily favors those listed in China, which compromises the fund’s country diversification. Over the past few years, the addition of A-shares means China’s weight has grown to over 30% of the fund’s assets. While not extreme, investors would do well to monitor the portfolio’s allocation to Chinese stocks.

A Quick Look At Two Competitors

Earlier in the article, you doubtless noticed references to taking a quick look at a couple of SCHE’s competitors, as well as a note to the effect that they might offer even better value.

Those two competitors are Vanguard FTSE Emerging Markets ETF (VWO) and iShares Core MSCI Emerging Markets ETF (IEMG).

To facilitate an easy side-by-side comparison of some key features, I developed the following table for you.

As can quickly be seen, both VWO and IEMG have some commonalities when compared to SCHE. First off, they both offer slightly better expense ratios as well as trading spreads. Since both are roughly 8-9x the AUM of SCHE, this likely comes as no surprise.

Secondly, both competing ETFs dive a little deeper into the market, adding a mix of small-cap securities into the equation.

Before we get into some brief specifics on each competitor, I want to call one key item to your attention. Please note that The FTSE-developed indexes used by both SCHE and VWO do not include South Korea. This is because FTSE classifies South Korea as a developed market. In contrast, MSCI, the index provider for IEMG, classifies South Korea as an emerging market.

The key takeaway? If as opposed to a total-market international ETF, such as Vanguard Total International Stock ETF (VXUS) or iShares Core MSCI Total International Stock ETF (IXUS), you wish to use discreet ETFs to manage your developed vs. emerging market holdings, you want to pick two from the same family, so that you do not end up with either overlapping, or zero, exposure to South Korea.

Finally, one last commonality. Following Russia’s invasion of Ukraine, both FTSE and MSCI removed Russia from their emerging market indexes. As a result, all 3 ETFs are following suit, gradually removing Russian securities from the fund.

Quick Comments – Vanguard VWO

Here, from Seeking Alpha, is a nice overview of VWO. Please note that, similar to SCHE, South Korea is not included in this ETF. As a result, the overall country weightings are reasonably close between the two funds.

Besides the lower expense ratio and trading spread that VWO offers, perhaps the most striking difference is the number of securities included in VWO. With 5,438 holdings, VWO contains almost 3x as many securities as SCHE. Even though, as mentioned above, the country weightings are relatively similar, the greater dilution takes VWO’s concentration in its Top 10 holdings down to 20.00%, as opposed to 22.52% in SCHE.

In short, VWO provides the broadest and most complete exposure to emerging markets, in combination with the lowest overall expenses.

Quick Comments – iShares IEMG

Here, from Seeking Alpha, is a nice overview of IEMG. Please note that, different from SCHE, South Korea is included in this ETF, in fact, it carries an overall weighting of roughly 13%. As a result, the relative weighting of other countries, including China, is reduced.

Similar to VWO, IEMG offers a lower expense ratio and trading spread than VWO. Additionally, due to the inclusion of small-cap equities, IEMG could be considered to offer slightly better diversification than SCHE. IEMG’s Top 10 holdings comprise some 20.87% of the fund, virtually splitting the difference between SCHE’s 22.52% and VWO’s 20.00%.

Summary and Conclusion

As featured in the introduction, there may be a good reason for all but the most risk-averse investors to include at least some allocation to emerging markets. While these markets face many challenges and a significant level of uncertainty, it could be argued that this is fully priced into the shares, opening up a corresponding window of opportunity.

SCHE is a top-quality ETF that investors may wish to consider for such exposure. At the same time, my personal choice remains VWO.