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Why Rules Matter With Emerging Markets Investments

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With just a few trading days left in 2018, investors have heard plenty about emerging markets equities and exchange traded funds (ETFs) this year and little of what they have heard has been positive.

As of Friday, Dec. 21st, the widely followed MSCI Emerging Markets Index is down 16.50 percent on a year-to-date basis, meaning the developing world benchmark is poised to snap a two-year winning streak and close lower on an annual basis for the fourth time in the past six years.

Some factor-based emerging markets strategies are performing less poorly than cap-weighted benchmarks this year. The JPMorgan Diversified Return Emerging Markets Equity ETF (JPEM) has been 450 basis points less bad than the MSCI Emerging Markets Index while being noticeably less volatile than that index.

COURTESY: ETFREPLAY

The JPMorgan Diversified Return Emerging Markets Equity ETF (JPEM) follows the rules-based JP Morgan Diversified Factor Emerging Markets Equity Index. Rather than relying on market capitalization, the JP Morgan Diversified Factor Emerging Markets Equity Index emphasizes the value, quality and momentum factors.

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Making A Difference  

As the aforementioned year-to-date performances indicate, there are clear advantages to JPEM’s relative to cap-weighted indexes. Obviously, returns generated by emerging markets equities this year are nothing to write home about, but the JPMorgan Diversified Return Emerging Markets Equity ETF (JPEM) has notched two positive quarterly performances this year (first and third) compared to just one (first) for the MSCI benchmark.

On a monthly basis, JPEM has three monthly losses in 2018 of 4 percent or more while the MSCI Emerging Markets Index has four such showings. Over the past 25 months, the JPMorgan Diversified Return Emerging Markets Equity ETF (JPEM) has been negative in nine of those months compared to 10 down months for the MSCI Emerging Markets Index.

COURTESY: ETFREPLAY

Why Factors Matter

With U.S. stocks, funds weighted by market capitalization can introduce elements of individual security or sector concentration risk. Cap-weighted emerging markets strategies can subject investors to those risks as well as geographic risk. For instance, the MSCI Emerging Markets Index devotes over 30 percent of its weight to Chinese stocks, more than its allocations to its second- and third-largest country weights (South Korea and Taiwan) combined.

That is fine when Chinese stocks are going up, but that is not the case this year. Having been hammered by trade tensions with the U.S., Chinese equities are among 2018’s most egregious emerging markets offenders, as highlighted by a year-to-date decline of 12.62 percent for the FTSE China 50 Index.

The JPMorgan Diversified Return Emerging Markets Equity ETF (JPEM) features a China weight that is nearly 1,000 basis points below what is found in the MSCI Emerging Markets Index. There are also cases of addition by subtraction. MSCI still classifies South Korea, Asia’s fourth-largest economy, as an emerging market. FTSE Russell, JPEM’s index provider, classifies South Korea as a developed nation. That exclusion is palpable in a year in which South Korea’s benchmark Kospi is down 17 percent.

Asian economies are among the higher quality fare and likely to lead any emerging markets rebound in 2019. Despite excluding South Korea and being underweight China relative to the MSCI benchmark, the JPMorgan Diversified Return Emerging Markets Equity ETF (JPEM) devotes about two-thirds of its geographic weight to ASEAN nations, China, India and Taiwan.

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