Emerging market equities are likely to outperform in the coming months, as the ongoing economic recovery boosts their lagging share prices, valuations, and the strength of their underlying currencies.

The Vanguard FTSE Emerging Markets ETF (

(Source: IMF)

Emerging market equities, however, have significantly underperformed, as these, or VWO at least, are overweight some of the hardest-hit industry segments, including financials and energy, compared to the S&P 500:

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(Source: ETF.com)

Both U.S. and international financial indexes have fallen, as the outbreak pressures the revenues, earnings, and asset values of banks and other financial services companies:

ChartData by YCharts

Energy companies have also underperformed as commodity prices, especially oil, have decreased, due to reduced demand and a weakening global economy:

ChartData by YCharts

Emerging markets have also seen their currencies collapse in value, due to decreased exports (fewer exports = fewer dollars = expensive dollar). The U.S. dollar has rarely been this expensive vis-a-vis emerging market currencies:

Emerging market equities trade in their local currencies, so as these are devalued, U.S. investors (who care about the value of their investments in USD) see significant losses.

Investors have, understandably, fled emerging markets, selling billions of dollars’ worth of stocks, leading to the aforementioned collapse in equity prices and valuations. Emerging market equities both sport relatively low price-to-earnings and price-to-book ratios, at least compared to the S&P 500:

(Source: ETF.com – chart by author)

The investment thesis for emerging market equities is also quite simple.

Improved economic and industry conditions should lead to increased corporate revenue and earnings, leading to higher share prices, stronger valuations, and more expensive currencies, ultimately resulting in outsized shareholder returns. Economic fundamentals are already quite strong, so the possibility of further growth and a strengthening recovery seems high. As such, I believe that emerging market equities will outperform in the coming months and years.

There is precedent.

There have been three past periods in which emerging markets and currencies were as weak as they are today: January 2006, March 2009, and January 2017.

Emerging market equities significantly outperformed in the months and year after these periods, by double digits. The returns themselves were of at least 29% in the following year:

ChartData by YCharts
ChartData by YCharts
ChartData by YCharts

In my opinion, and as has happened in the past, emerging market equities will soon see stronger share prices and valuations, leading to outsized shareholder returns. Emerging market currencies should also increase in value, in turn also leading to increased shareholder returns.

On the other hand, I do want to emphasize that results are strongly contingent on economic conditions. Emerging market equities should underperform if the coronavirus outbreak worsens or the recession deepens, as was the case earlier in the year. I’m quite bullish about future economic conditions, so I don’t believe this to be likely, but it is definitely a possibility.

With the above in mind, let’s take a look at VWO.

Fund Basics

  • Sponsor: Vanguard
  • Dividend yield: 8.44%
  • Expense ratio: 0.10%
  • Total Returns CAGR (NAV – 10Y): 6.96%
  • Discount to NAV: 14.44%

Fund Overview

VWO is the largest emerging market equities ETF in the world, with over $62 billion in AUM. The fund provides investors with a simple and cheap way to invest in emerging market equities, and has the same investment thesis and benefits as these.

VWO is administered by Vanguard, the second-largest asset manager and ETF provider in the world. Its unique corporate structure is a key competitive advantage. Vanguard is structured as a mutual company; it is owned by its investors/investment funds, so any and all profits are ultimately returned to investors in the form of lower fees. Vanguard’s very structure ensures that the company works for and enriches its investors, while the opposite is usually true for its peers, in my opinion at least.

VWO tracks the FTSE Emerging Markets All Cap China A Inclusion Index, a broad-based market-cap weighted emerging market equity index. It invests in all emerging market equities that meet a basic set of criteria, centered on liquidity, trading, market cap, and the like.

Importantly, the fund is able to invest in Chinese A-shares, which are generally off limits to non-Chinese investors due to government regulations. These are further weighted according to foreign investor allocations / allowances. As allocations increase, so do weights.

Due to the above, and owing to China’s large economy and corporate sector, VWO is heavily overweight Chinese equities, with these comprising about 44% of its holdings:

(Source: ETF.com)

At the same time, and for the same reasons, the fund is overweight Asia:

(Source: ETF.com)

Chinese giants Alibaba (BABA) and Tencent (OTCPK:TCEHY) are, understandably, the fund’s two biggest holdings:

(Source: ETF.com)

I’m somewhat bearish about Chinese equities in particular, due to the worsening of trade relations with the U.S. and the possibility of adverse regulatory actions from the U.S. government. Still, China is the largest emerging market economy, and Asia is the largest region, and the fund reflects that.

VWO is well-diversified across industries, although, as mentioned previously, the fund is moderately overweight financials and energy, at least compared to the S&P 500:

(Source: ETF.com)

VWO’s underlying index, overall investment strategy, and holdings provide investors with all the emerging market equity exposure they need, so the fund is perfect for investors wishing to invest in these securities.

Conclusion – Strong Buy

Emerging market equities and currencies are looking undervalued. Improved economic conditions should lead to rising equity prices and valuations, as well as strengthening currencies, ultimately resulting in strong shareholder returns. VWO provides investors with a simple and cheap way to invest in these securities and is a Strong Buy.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.