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Vanguard Emerging Markets (VWO -0.64%) is arguably the top ETF (exchange-traded fund) to invest in emerging markets stocks.Companies in emerging markets look quite undervalued in comparison to their counterparts in the U.S., and this could be creating a buying opportunity for investors who are brave enough to go hunting for bargains overseas.
Emerging markets stocks look undervalued
The following chart compares Vanguard Emerging Markets versus SPDR S&P 500 ETF (SPY 0.15%), a popular ETF that tracks the S&P 500 index. Since the current bull market started, around March 2009, companies in the U.S. have more than doubled emerging markets stocks' results on a total return basis, meaning dividends plus capital gains.
SPY Total Return Price data by YCharts.
We can mention several possible reasons why companies in the U.S. have done much better than emerging markets stocks over the past several years. Political uncertainty, weak commodity prices, and economic instability in countries such as China, Russia, and Brazil are some of the main factors that come to mind.
On the other hand, most of these problems are already incorporated into valuations to a good degree, and emerging markets stocks are far cheaper than companies in the U.S. The following table compares valuation ratios such as forward price-to-earnings, price-to-book-value, price-to-free-cash-flow, and dividend yield for companies in Vanguard Emerging Markets against those in the SPDR S&P 500. The conclusion is quite clear: Across the board, companies in emerging markets are materially cheaper than those in the U.S.
| ETF | Forward P/E | Price/Book Value | Price/Free Cash Flow | Dividend Yield |
|---|---|---|---|---|
| Vanguard Emerging Markets | 13.26 | 1.49 | 4.04 | 3.64% |
| SPDR S&P 500 | 19.14 | 2.63 | 10.34 | 2.28% |
Data source: Morningstar.
Emerging markets stocks are more volatile than companies in developed markets, and this is a relevant consideration to keep in mind. However, true investment risk is not about volatility in isolation; investors need to consider how a particular investment would blend into their overall portfolio mix.
If your portfolio is too tilted toward companies in the U.S. and other developed countries, then adding some emerging markets stocks to the mix can be a smart way to increase diversification levels. When building a solid portfolio for the long term, proper diversification is one of the most important aspects to keep in mind, and emerging markets stocks have a lot to offer in that area.
The best emerging markets ETF
Investors currently have access to a wide variety of choices in emerging markets ETFs, but the Vanguard product comes second to none. Vanguard Emerging Markets invests in a basket of nearly 900 companies from 22 countries in the emerging markets category. China and Taiwan are the two biggest countries in the portfolio, accounting for 27.5% and 15.4% of assets respectively. These countries are followed by India (12.2%), Brazil (8.7%), South Africa (8.7%), Mexico (4.5%), and Russia (4.1%).
Data source: Vanguard.
In terms of portfolio construction, Vanguard Emerging Markets is quite similar to other emerging markets ETFs such as iShares MSCI Emerging Markets (EEM -0.48%). However, there is one important difference to keep in mind: The Vanguard fund is in the process of adding Chinese A shares to the portfolio. These are the local shares of Chinese companies trading in Shanghai and Shenzhen --securities the are excluded from vehicles such as iShares MSCI Emerging Markets.
Chinese regulations impose a series of restrictions on foreign investors, who are not allowed to freely buy A shares directly. For this reason, investing in Vanguard Emerging Markets could be a smart way for U.S. investors to avoid those limitations and get access to Chinese A shares.
Plus, Vanguard Emerging Markets has a huge advantage versus the competition in terms of costs. The ETF has an annual expense ratio of 0.15%. According to Vanguard, the average expense ratio for similar funds is a much-higher 1.5%. As a reference, iShares MSCI Emerging Markets, probably its main competitor, charges an annual expense ratio of 0.71%.
Emerging markets stocks look far cheaper than companies in the U.S. market, and this bodes well in terms of potential returns going forward. If you are looking for a low-cost ETF providing transparent and diversified exposure to emerging markets stocks, then Vanguard Emerging Markets looks like a solid candidate to consider.
