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Introduction
It is said ETFs are a great way to play the market for the long-term. However, for some of these funds, this notion has become just cliché. Such financial products are instead totally legitimate, but highly speculative bets on specific countries and economic sectors without a warning label for investors. The cap-weighted indexing methodology being the culprit, one perfect example of this problem is the Vanguard FTSE Emerging Markets ETF (VWO).
While there are a total of 4,718 holdings in VWO, the fund is a heavily-skewed play towards China, and in particular Chinese tech and financial sectors. According to the FTSE Russell Research Portal, the current weight of China in the FTSE Emerging Index is now over 1/3 of the total. This simply means that while there are 24 markets in the index, including large trading centers like Taiwan (12.7%), India (11%), and Brazil (9%), the performance of this fund depends for the most part on the destiny of one single country, and two sectors (tech and financial). Unfortunately, many investors buy these products for broad diversification, without realizing they are buying something completely different.
Top Holdings
A look at the fund’s holdings is sufficient to reveal investors the truth: the top 2 Tencent Holdings (OTCPK:TCEHY) and Alibaba (BABA) constitute alone almost 10% of the fund. When investors consider that the fourth holding’s, Naspers (OTCPK:NPSNY), most valuable asset is its equity stake in Tencent, that percentage is even higher.
Source: FTSE Russell Research Portal
Five out of the top ten holdings are either Chinese tech or finance companies, and based on its significant stake in Chinese equities, the total could be six. Concentration is also a factor as the top 10 holdings account for over 23% of the total holdings of the fund and accounting for the Naspers oddity that figure is closer to 24%. To provide some contest, the Vanguard Total World Stock ETF’s (VT) top 10 holdings account for just about 10% of the total, and even in the SPDR S&P 500 Trust ETF (SPY), which includes in its top 10 holdings five out of the six FAANGM stocks – the only excluded being Netflix (NFLX) – the 10 largest holdings concentration stops at around 21%. The fund is, therefore, a concentrated bet, far from the stated objective of the fund to broadly “track the performance of a benchmark index that measures the investment return of stocks issued by companies located in emerging market countries. Such a gamble on a handful of companies within a single country and two sectors is not the typical long-term game passive investor play with an Index ETF, but could instead be a bullish call timed according to fundamentals or possibly other factors like currency movements.
Risks tied to China-specific uncertainties
In light of VWO’s high concentration on China, I see several dangers here, related to the outcomes of specific Chinese domestic and international issues.
- A failure of China-US trade negotiations: The trade war is ongoing, and while President Trump has recently delayed (but not suspended) by two weeks a new $250 billion tariff hike as a “gesture of goodwill”, that could quickly reverse if no progress is made. While the two parties officially maintain they are willing to hold talks, neither one seems ready to give away concessions to the other. As a result, a settlement does not look anywhere in sight.
- The “Great Wall” of Chinese Debt: China’s problems are much more profound than trade. Its excessive debt is no news, but there are troubling signs that the situation is getting out of hands. On the one hand, private debt has skyrocketed, fueled by the housing bubble. The IMF expects household debt to rise to 56.2% of GDP in 2019, and as high as 67.9% of GDP in 2024. The 2024 levels are above Japan and the Eurozone. Individuals are amassing property-related debt at a fast clip with no end in signs, and Chinese banks (those same banks among the top 10 VWO holdings) are printing trillions of yuan out of thin air to support this. On the other hand, mortgage debt is just the tip of the iceberg. The situation at the corporate level is even more worrisome, and this is no surprise in a country where growth comes ahead of profits. China owns and operates most of the leading businesses in the O&G, telecom, and RE development. Since some of these companies are listed entities, they too end up within VWO. However, these companies are not profit driven, but growth driven. The businesses receive massive subsidies to operate, with banks very willing to lend to state-owned corporations as much cash as they need. Overall credit-to-GDP has now grown to around 300% from about 150% in 2007. For comparison, this figure was nearly 350% in US just before the 2007-2008 financial collapse, so there’s little doubt this factor alone puts China’s banking sector firmly in the crisis category. The only remaining positive is the low debt-to-GDP levels, which could help China in the event the country will have to bail in its banks, but it is hard not to forecast any financial trouble under such scenario.
Source: Columbia Threadneedle Investments website
- Government crackdown: While the risk seems remote for established companies such as Tencent or Alibaba, investors should note that the possibility of unpredictable, sweeping state intervention is something more than hypothetical. Momo Inc. (MOMO) investors are well aware of this threat. Shares of the company dived last April following the government decision to remove dating app Tantan from online stores and then suspending it for one month.
Some of the risks described above are not short-term in nature and investors could face possible capital losses very hard to recoup. On the other hand, the bull call could still bear fruits for the longs, resting primarily on the case that the valuation gap between Chinese companies and their US counterparts will likely close. However, it is hard to contend that such a discount is indeed warranted.
Different ways to play EM
To sidestep these issues, I see two different ways to incorporate EM in a broad equity strategy.
The first way is to buy and hold the Vanguard Total World Stock ETF, which besides having an even better expense ratio (0.09% vs. 012%), offers an excellent choice for investors who want an “all-in-one” product. The ETF covers stocks of all sizes listed in both developed and emerging markets. With its broad exposure, the fund’s top 10 holdings are only about 10% of the total ETF assets, therefore making concentration risk very low. By also incorporating the US markets, the fund also mitigates the longstanding issue of EM underperforming the US in the past two decades. On the flip side, investors end up holding duplicates of individual picks they make. Those looking for a purely international hedge, therefore, can opt for the Vanguard Total International Stock ETF (VXUS), which includes all non-US markets and has the same 0.9% expense ratio of VT. For passive investors having VT or VXUS in their portfolios, I see no compelling reasons to hold VWO.
Those who are more bullish on EM prospects and want exposure to these markets regardless of past performance can opt for a different, value approach. The iShares Emerging Markets Dividend ETF (DVYE), which tracks the Dow Jones Emerging Markets Select Dividend Index, focuses on an income strategy, and the ETF has a radically different approach from VWO. The fund offers a high current yield of 7% and still provides exposure to a broad range of companies in EM countries. The expense ratio on this ETF is a bit rich at 0.49%, but since competing products are few and far between, the charge seems reasonable.
Geographically, the composition is slightly more diversified, with China being 10.8% of the total, but with both Taiwan (20%) and Russia (17%) having a significant presence instead. However, this fund typically holds only 100 or so firms and the geographical equilibrium is subject to change much more quickly at each rebalancing than the much more stable weighting of VWO.
Source: iShares DVYE Factsheet
This ETF is also a fair “value” pick since mean P/E stands at 8.4x and P/B at 1.2x. Those interested in a deeper dive into DVYE can check the informative article written by fellow contributor Nairu Capital, which I highly recommend.
Conclusion
Also in the seemingly safe space of ETF replicating broad indexes, investors are required to check carefully the risks which come with the package. Although there is no question VWO is a legitimate product, investors shouldn’t judge the book by its cover and get this ETF for broad EM exposure.
The bull case for VWO seems speculative since the fund performance relates closely to China and the outlook on its financial and tech sectors. Thus, I find difficult to recommend this product for the usual long-term oriented, dollar-cost-averaging strategy usually associated with ETF. Passive investors can get a fair amount of EM exposure through other Vanguard products such as VT and VXUS. Those who feel more adventurous and have an income focus instead can try to hedge their US holding with DVYE, which offers a radically different approach, avoiding the pitfalls associated with VWO.
Disclosure: I am/we are long DVYE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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