A Different Approach To Emerging Markets ETFs

Following another year of dreadful performances by emerging markets equities and the related exchange-traded funds, now is as good of a time as any for investors to rethink how they approach developing world stocks.

Part of the recalibrating process with emerging markets ETFs includes identifying why so many traditional funds of this ilk have struggled in recent years. A significant part of the problem lies with state-owned companies, meaning companies where an emerging markets government is a major government. Think Chinese banks and Latin American oil companies such as the infamous Petroleo Brasileiro SA Petrobras (ADR) PBR.

Related Link: An Emerging Markets ETF Rebound Candidate For 2016

Fortunately, there are some ETFs devoted exclusively to the concept of avoiding state-owned companies. That group includes the WisdomTree Emerging Markets Ex-State Owned Enterprises Fund XSOE. Putting XSOE in a somewhat positive light, the ETF has been less bad than traditional emerging markets ETFs over the past year. XSOE is down 15.4 percent over that time compared to a 19 percent loss for the MSCI Emerging Markets Index.

Your Typical, Everyday, Standard Emerging Markets ETF

When it comes to standard emerging markets ETFs, investors can often expect big doses of the energy, financial services and telecom sectors – groups that dominated by state-owned companies. That is not the case with XSOE, as telecom and energy combine for less than 16 percent of the ETF's weight.

XSOE Isn't Typical

“We screen the universe of emerging markets companies annually, and as of the September 30, 2015, Index screening, more than 40 percent of the market capitalization of ‘state-owned’ firms that we found was in the Financials sector. Beyond that, nearly 20 percent of the market capitalization was in Energy companies, and more than 10 percent was in Telecommunication Services. So, nearly three-quarters of the market capitalization of state-owned enterprises was in those three sectors,” said WisdomTree in a recent note.

The drag on XSOE is what should be a catalyst when the ETF reverses course: heavy technology exposure. XSOE is heavily allocated to the technology sector, as well as some formerly high-flying Chinese Internet stocks that trade in New York, including Alibaba Group Holding Ltd BABA and Baidu Inc (ADR)) BIDU. Additionally, XSOE is heavily allocated to tech-rich nations such as South Korea and Taiwan.

“In Information Technology, the relative over-weight to Chinese companies – many of which list on the New York Stock Exchange – has benefited performance. In Energy, avoiding the largest companies in Brazil and China has helped relative performance. Of course, over these periods, the performance across nearly every sector in emerging markets was, in a word, challenged, so this was really a story of avoiding some of the worst performing firms as opposed to selecting companies that are actually seeing positive performance,” added WisdomTree.