IEMG: The Case For Emerging Markets (NYSEARCA:IEMG)

Introduction

The iShares Core MSCI Emerging Markets ETF (NYSEARCA:IEMG) has underperformed the SPDR S&P 500 ETF Trust (SPY) so far in 2024, delivering a mid-single-digit total return against the circa 15% gain in the benchmark ETF:

Over a 3-year, 5-year, and 10-year timeframe, the underperformance is even more significant, at around 37%, 76%, and 204%, respectively:

While there is no guarantee the trend of the last decade will reverse, I think there are several factors that can turn the tide in emerging markets’ favor. Firstly, the IEMG offers a higher earnings and dividend yield relative to the SPY. Secondly, constituent countries’ GDP growth rates are likely to exceed those of the United States, both short-term and over the long term. Last but not least, the underweight position in Information Technology relative to the SPY makes sense in my opinion given expensive valuations in the sector after recent outperformance.

ETF Overview

You can access all relevant IEMG information on the iShares website here. The iShares Core MSCI Emerging Markets ETF tracks small, mid, and large-capitalization companies from emerging markets. The portfolio is fairly concentrated in a few major emerging market countries, namely China (21.86% of net assets), India (21.09%), Taiwan (19.68%), and South Korea (11.80%):

From a sector perspective, the allocation is primarily to Information Technology (23.72% of net assets), followed by Financials (20.46%) and Consumer Discretionary (12.06%):

Diversification, expenses, and distributions

The total number of IEMG holdings is 2 943, with the full list available here. The top ten positions account for 22.04% of net assets, which is arguably better diversification than the 34.26% concentration in the top ten holdings in the SPY. Nevertheless, we should mention the outsized single-stock exposure to Taiwan Semiconductor Manufacturing Company (TSM) which accounts for 8.35% of IEMG’s net assets.

The expense ratio stands at 0.09%, which is a very attractive level, in line with SPY’s 0.0945% level. The IEMG ETF makes distributions twice a year versus quarterly payments at SPY.

Sector allocation comparison

In the table below, I will now evaluate how the IEMG compares to the SPY from a sector perspective:

Click to enlarge

Source: Author calculations based on iShares and State Street disclosures

Looking at the data above, we observe IEMG is heavily underweight Information Technology (by 7.62%) and Health Care (7.88%). Given elevated valuations in the Information Technology space, I think it makes sense to underweight the sector. The Health Care underweight does not seem prudent given the defensive nature of the sector and long-term growth prospects. On the other hand, if you look at the iShares Global Healthcare ETF (IXJ), we find that it offers an earning yield of 3.26% and a dividend yield of just 1.29% which seems overvalued, so perhaps the good long-term prospects are already priced in.

Turning to the sectors, IEMG is overweight, we observe that Financials (7.41%) and Materials (5.22%) are the two biggest differences. Financials is traditionally a value sector, but I would argue that given the current prospect for interest rate cuts, you would have to be selective when allocating capital for the sector. Hence, the overweight position is perhaps not prudent. The Materials overweight position arguably makes more sense, as the sector should benefit from the electrification trend, which is unlikely to stop any time soon. Furthermore, the iShares Global Materials ETF (MXI) offers an earnings yield of 5.29% and a dividend yield of 2.68%, which is reasonable.

Going over the differences in the remaining sectors, they are overall not that significant, with a marginally higher allocation to Consumer Discretionary (2.21%) giving IEMG a somewhat more cyclical tilt, which is already evident from the larger Financials/Materials allocation, respectively the Health Care underweight position.

Valuation and growth prospects

IEMG currently boasts an earnings yield of 6.30% and a dividend yield of 2.79%, quite higher than SPY’s 4.45% forward earnings yield and its current dividend yield of 1.26%. As a result, S&P 500 earnings would have to grow some 1.85% faster than IEMG earnings for the SPY ETF to make up for the valuation difference, something I don’t think is sustainable long term.

In fact, emerging markets are forecast to outpace US growth in 2024-2025, as evident from the International Monetary Fund’s July 2024 World Economic Outlook Update:

We observe the United States is forecast to grow 2.6% and 1.9% in 2024 and 2025 respectively, much slower relative to a circa 5% growth for the largest IEMG components India and China. While it is true that GDP growth will not necessarily translate into earnings growth, it is commonly accepted that emerging markets will grow faster than high-income economies due to pure catch-up growth.

Risks

Investing in emerging markets brings a number of idiosyncratic risks. One risk that came to the attention of investors recently is the risk of capital controls as the ones imposed by Russia following its 2022 invasion of Ukraine. Hence, there is no guarantee investors will be able to get a fair price for their assets in such an event.

Institutional protection is arguably also less developed as compared to established capital markets, with numerous examples of questionable court decisions, outright fraud, or poor investor protection.

Currency risk is also front and center when allocating capital to emerging markets, with each country having its own set of monetary policy considerations. Given the attractive valuations, you may well make a reasonable profit in local currency terms, but when calculated in hard currency such as the US dollar, you may end up worse than a simple SPY investment.

Conclusion

The iShares Core MSCI Emerging Markets ETF has underperformed the SPDR S&P 500 ETF Trust in literally every time frame in the past ten years. As things stand, I think emerging markets may outperform going forward, thanks largely to a more attractive valuation from an earnings yield perspective, better GDP growth prospects relative to high-income markets such as the United States, and perhaps helped by an underweight position in Information Technology sector compared to the S&P 500.

While there have been many false dawns for emerging market stocks in the past and these markets come with numerous risks, I still think it makes sense to increase allocations to ETFs such as the IEMG which will benefit from emerging markets outperformance. Against the backdrop of a looming presidential election, which will create some uncertainty in US stock markets in the months ahead, I recommend going long the IEMG ETF.

Thank you for reading.