Under the Hood: Emerging-Markets Yields Be on the lookout for the unintended bets hiding in emergingmarkets

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1 ? Under the Hood: Emerging-Markets Yields Be on the lookout for the unintended bets hiding in emergingmarkets dividend funds. Morningstar Inc. June Monika Dutt Executive Summary In today s world of zero and, in some cases, subzero interest rates, it isn t hard to understand the appeal of dividend strategies. While many investors have turned to developed-markets equity dividend funds, emerging markets have recently come back in favour. In the months of March, April and May, Europedomiciled emerging-markets dividend-oriented exchange-traded funds pulled in some of their highest historical inflows. But investors considering the addition of an emerging-markets dividend fund into their portfolio need to consider far more than its yield. We took a closer look at the emerging-markets dividend ETF landscape and found that: Emerging-markets dividend-oriented ETFs have paid out around 4%-6% in annual dividend yields over the past three years. By comparison, dividend yields for average market-cap-weighted emergingmarkets ETFs have been lower, at around 2%. However, in total return terms, these ETFs have underperformed their market-cap-weighted counterparts, mostly because of their country and sector tilts. Different index methodologies create sector and country biases, relative to the widely followed MSCI Emerging Markets Index. Taiwan and Brazil have overweightings, while India and South Korea are barely represented in the three ETFs under study. Emerging-markets dividend ETFs have an underweighting in consumer names--companies likely to benefit from the growing middle class in developing economies. Introduction Rock-bottom interest rates have created a challenging environment for investors eyeing a decent and fairly reliable income stream. Many investors are turning towards dividend-oriented strategies to compensate for the low yields bonds offer. Aside from providing investors with income, dividend-paying companies tend to have stronger corporate-governance structures in place. As such, dividend equity funds often provide access to betterquality holdings, but this is not always the case. While many investors associate stable equity dividends solely with developed economies, the concept is also applicable to emerging markets. And exchange-traded funds have facilitated access to that asset class.

2 Page 2 of 7 In this paper, we analyse the characteristics of the main emerging-markets dividend ETFs domiciled in Europe, namely the SPDR S&P Emerging Markets Dividend, ishares Emerging Markets Dividend, and WisdomTree Emerging Markets Equity Income ETFs. (See Exhibit 1.) We aim to tease out the differences between these ETFs and help investors more prudently choose in order to reach their goals. We offer an overview of the emerging-markets dividend landscape, highlighting the key drivers of, and risks to, performance. We then analyse the differences in the construction of the funds underlying indexes. We conclude by highlighting some of the more prominent country and sector biases that we believe are worth considering when selecting a dividend-oriented emerging-markets fund. Exhibit 1 Emerging-Markets Dividend ETFs Domiciled in Europe Source: Morningstar Direct. Data as of 06/06/16. Yield and Total Return Emerging-markets equity funds have been down for three consecutive calendar years. The MSCI Emerging Markets Index in U.S. dollar terms has declined 14.72% on an annualised basis, over the past three years through May. By contrast, the MSCI World--the benchmark of reference for global developed markets--grew by 19.06%. Looking forward, the International Monetary Fund projects that global growth will remain muted amid China s economic slowdown, deeper-than-expected downturns in Brazil and Russia, and continuing commodity headwinds. Historically speaking, during economic downturns, investors flock to riskreducing or quality-screened strategies, which tend to outperform the general market during more bearish climates. Generally, dividends are associated with defensive characteristics. Most firms in traditionally defensive sectors of the economy--utilities, telecoms, healthcare, and consumer staples--tend to provide aboveaverage dividend yields, as well as a smoother ride through cyclical swings in the economy. This makes such stocks easier to hold through bouts of uncertainty. And in fact, the data shows that during what has been a bad period overall for the asset class, emerging-markets dividend funds have delivered higher yields than their market-cap-weighted cohorts. On average, the three ETFs have managed to pay around 4%-6% in annual dividend yields over the past three years. By comparison, dividend yields for average market-cap-weighted emerging-markets ETFs have been lower, at around 2%.

3 Page 3 of 7 However, in total return terms, all three dividend-oriented emerging-markets ETFs underperformed the MSCI Emerging Markets Index since their respective inceptions (see Exhibit 2), mostly because of their country tilts, which were not best suited for recent market conditions, namely falling oil prices. The extent of underperformance varies among the three ETFs, given each fund tracks a different index. Exhibit 2 Total Returns for Emerging-Markets Dividends ETFs Source: Morningstar Direct. Data as of 24/06/. First, dividend-oriented emerging-markets ETFs had overweightings in commodity exporting countries. For example, countries like Brazil, South Africa, and Russia have laws supporting higher-dividend payout ratios, and as a result companies in these countries pay higher dividends. Meanwhile, companies in countries like India tend to reinvest capital to fuel growth, instead of paying dividends. Second, emerging-markets funds were punished by negative currency translation effects. The Brazilian real, the Russian ruble, and the South African rand declined by 40%-50% against the U.S. dollar during the past three years. Over the same period, the MSCI Emerging Markets Index in U.S. dollars terms declined 14.72% but rose 3.83% in local currencies. With the Fed s softer stance on interest rates and a stabilisation in commodity prices, emerging-markets ETFs have recently started to rebound. But investors considering a dividend-oriented emerging-markets fund need to carefully examine the screening criteria of its underlying index to better understand the various biases and possible risks involved with owning such a fund. Varying Approaches The SPDR s S&P Emerging Markets Dividend Opportunities Index, ishares Dow Jones Emerging Markets Select Dividend Index, and WisdomTree Emerging Markets High Dividend Index all cover the full market-cap spectrum, ranging from large- to mid- and small-cap stocks.

4 Page 4 of 7 With over 400 stocks, the WisdomTree Index offers the broadest exposure to emerging-markets dividend-payers, while the other two indexes only include 100 stocks each, exposing investors to higher idiosyncratic risk. The most concentrated indexes at the security level are the S&P and WisdomTree indexes, with 31% and 26% of their value in the top 10 holdings, respectively, compared with 19% for the Dow Jones index. To ensure diversification, each index caps country levels at 25%. In addition, the WisdomTree and S&P indexes cap sector weights at 25% and individual security weights at 3% and 5%, respectively. All three indexes apply profitability screening criteria. For S&P and Dow Jones, profitability is measured by using the 12-month trailing earnings-per-share ratio, while WisdomTree only includes companies that have paid cash dividends of at least $5 million on common shares in the annual cycle prior to the annual index screening date. To screen out potentially distressed names, only the S&P Emerging Markets Dividend Opportunities Index requires companies to meet sustainability requirements by screening for three years of positive earnings growth. Three years may not seem like a lot compared with developed markets, but the emerging-markets asset class is relatively young, with limited availability of historical data. By comparison, the SPDR S&P US Dividends Aristocrats ETF and SPDR S&P Euro Dividend Aristocrats ETF include stocks that have paid increasing or stable dividends for at least 20 and 10 years, respectively. Meanwhile, the Dow Jones Emerging Markets Select Dividend Index requires stocks to have paid dividends during the past three years and only includes companies that have indicated positive annual dividend yields. Hoping to capture the next "rising stars," WisdomTree doesn t screen for sustainability at all. Some of these young, dynamic, and up-and-coming companies include Taiwan s Powertech Technology, which specialises in semiconductor assembly, Brazil s Aliansce Shopping Centers mall developer, and IT provider Asseco Poland Group. One glaring concern is that rising stars may tumble just as quickly as they soar. Once stocks pass each respective screening filter, they are ranked in descending order by annual yield. S&P and Dow Jones select the top 100 constituents for portfolio inclusion, while WisdomTree picks the highest 30% from the universe. Where the Dividends Are By geography, all three dividend ETFs demonstrate great divergence from the MSCI Emerging Markets Index. First, they all have significant underweightings in South Korea and India. In fact, South Korean stocks pay some of the lowest dividends in the world. Historically, domestic households and the South Korean government have viewed investing in the stock market as a highly speculative activity. But things are slowly changing. The government is loosening its dividend income tax policy, and more households are embracing stock ownership.

5 Page 5 of 7 In a quickly growing economy like India's, companies tend to reinvest capital to fuel growth instead of paying dividends--hence, the very little, if any, exposure to India these ETFs offer. Looking forward, this is expected to change as the Indian corporate culture continues to evolve. Exhibit 3 Country Exposure Source: Morningstar Direct. Data as of 31/05/ Also underrepresented in all three ETFs is China. As we write, China accounts for 18%-20% of total portfolio weight for both the WisdomTree EM Eq Inc ETF and ishares EM Div ETF, while it represents only 11% in the SPDR S&P EM Div ETF. By comparison, the MSCI Emerging Markets Index allocates almost a fourth of its total weight to Chinese stocks, which is high. And this allocation is likely to increase even further in the future as MSCI is planning on including China A-shares into its respective global equity indexes. At Morningstar, we suggest avoiding funds with a large China weighting, given the uncertainty around the country s growth, reforms, and currency regime in the near to medium term. That being said, China has been one of the largest contributors to returns for all three dividend-screened ETFs, mostly thanks to the renminbi s soft-dollar peg. In the coming years, this may no longer be the case as China is planning on liberalising its foreign exchange rates. Meanwhile, there seem to be a relatively large number of quality dividend-payers in Taiwan, with Taiwanese stocks making up about a fourth of all three ETF portfolios, double their weights in the MSCI Emerging Markets Index. Taiwan has been the largest market contributing to returns for WisdomTree since inception in 2014 because of a positive allocation and stock-selection effect. By contrast, Taiwanese equities were the largest detractor for ishares and SPDR since With 100 stocks only, ishares and SPDR are more prone to stock-selection risk, despite their morestringent requirements. Interestingly, other countries, namely Brazil, South Africa, and Russia, have laws supporting higher dividend payout ratios and, as a result, tend to be overrepresented in emerging-markets dividend indexes. For example, Russian companies like Gazprom and Rosneft were recently pressured to increase their dividend payout ratios to 50% from 25%, as the government needed to offset lost revenue caused by Western sanctions and falling oil prices.

6 Page 6 of 7 Because of its cash-dividend-screening criteria, the WisdomTree fund had an overweighting in Russia by approximately 8%-9% relative to the MSCI EM index, which consequently hindered the fund s performance in 2014 and However, with the price of oil stabilising since mid-february, the fund has started to rebound. With the onslaught of the commodity crisis, Brazil s two largest commodity exporters, Petrobras and Vale, have suspended dividends because of worsening profits. These state-controlled companies have been replaced in the indexes by financial-services firms, which have been able to uphold dividend payments thanks to their respective countries high interest-rate stance. In South Africa, Russia, and Brazil, where inflation remains high, companies are more inclined to distribute dividends than hold on to eroding cash reserves. The Rising Consumer? Dividend screened/weighted emerging-markets ETFs also deviate from the MSCI Emerging Markets Index at the sector level. Income-oriented emerging-markets ETFs tend to have greater exposure to utilities, materials, and telecoms. Meanwhile, they have underweightings in consumer staples, healthcare, and information technology. As developing countries converge to advanced economies, the middle class will rise because of urbanisation. Dividend-oriented strategies may not efficiently capture this shifting trend, as they have underweightings in consumer-focused firms like JD.com, Tencent, and Alibaba. Conversely, positively rated actively managed emerging-markets funds allocate a larger weighting towards consumer names-- companies more likely to benefit from rising consumption in the emerging markets. Exhibit 4 Sector Exposure Source: Morningstar Direct. Data as of 31/05/ Jury's Still Out On the whole, dividend-oriented emerging-markets ETFs have lagged their market-cap-weighted emerging-markets counterparts in recent years. But in all fairness, these strategies may have been launched during their worst possible days, and, by discarding them completely, we may be committing a serious case of time-period bias. All in all, the outlook for emerging markets remains murky, but with commodity prices and currency markets slowly stabilising, these strategies are regaining traction. For now, it s too early to tell. K

7 Page 7 of 7 About Morningstar Inc. Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offers an extensive line of products and services for individual investors, financial advisors, asset managers, and retirement plan providers and sponsors. Morningstar provides data on approximately 525,000 investment offerings, including stocks, mutual funds, and similar vehicles, along with real-time global market data on nearly 18 million equities, indexes, futures, options, commodities, and precious metals, in addition to foreign exchange and Treasury markets. Morningstar also offers investment management services through its investment advisory subsidiaries, with more than $180 billion in assets under advisement and management as of March 31,. The company has operations in 27 countries.? 1 Oliver s Yard City Road London EC1Y 1HQ Morningstar Inc. All rights reserved.