A costly choice for investing in emerging-markets stocks

iShares MSCI Emerging Markets ETF ( XEM ) offers broad, market-cap-weighted exposure to over 800 large- and mid-cap stocks across 23 emerging markets. It effectively diversifies risk, accurately represents its target market segment, and charges a 0.81% expense ratio, above the median in the Emerging Markets Equity category. But there are more affordable passive alternatives, one from Vanguard and one from iShares itself.

Similar to its market-cap-weighted peers, this exchange-traded fund has significant exposure to individual country risk. Despite the inclusion of 23 emerging markets, China (26%), South Korea (15%) and Taiwan (13%) jointly account for over half of the portfolio because of their large relative size. The same three countries make up less than 40% of the typical actively managed fund in the category. MSCI, the firm behind the fund's index, is also considering adding China A-shares , which would further increase the fund's allocation to Chinese stocks.

This broad portfolio effectively diversifies company-specific risk, but it has a larger-cap orientation than its typical peer. The top 10 holdings account for just over 20% of the portfolio, compared with 30% for the average fund in the category. These include Samsung Electronics,

Alibaba ( BABA ) and several Chinese banks. However, large-cap stocks account for nearly 90% of the portfolio. The corresponding figure for the diversified emerging-markets category average is just over 70%. Many large-cap emerging-markets stocks are multinational firms with global operations, such as Hyundai Motors, which generate a significant portion of their profits from outside their domestic market.

Fundamental view

Strong economic growth forecasts are often cited as a rationale for investing in emerging markets, but such growth has not translated into superior stock performance historically for several reasons. First, many of the larger firms listed in emerging markets generate a significant portion of their revenue and income abroad. This means that their profits can grow at a different rate than the domestic economy. Second, publicly traded companies often grow at a slower rate than their local economies because privately held companies drive a lot of that growth. Additionally, poor corporate governance in some emerging markets can lead to dilution of corporate earnings through new stock issuance.

Valuations also matter. From 2001-10, emerging markets handily outperformed developed markets. At the beginning of this period, emerging-markets valuations were below their historical average following several financial and political crises, while the valuations in the U.S. stock market were high following the historic 1990s bull market. Recently, emerging-markets valuations have declined relative to developed markets'. Over the trailing 10-year period through August 2016, the average difference in trailing 12-month P/E ratios for the MSCI World Index relative to the MSCI Emerging Markets Index was 2.7, showing emerging markets tend to trade at a lower valuation than developed markets. At the end of August 2016, the difference was 5.0, indicating emerging-markets valuations relative to developed markets are currently lower than their trailing 10-year average.

This fund offers a good way to get exposure to emerging-markets stocks. Its market-capitalization-weighting approach promotes low turnover and skews the portfolio toward large multinational firms. These companies tend to be more profitable and less volatile than their smaller counterparts. However, some of the fund's largest holdings are state-owned enterprises, which may be forced to prioritize political objectives over profit maximization. The fund's sector weightings are similar to the category average, but the fund has greater exposure to technology and less exposure to consumer defensive companies. Financial services and technology are the two largest sectors; each represents just over one fifth of the portfolio.

Emerging-markets stocks consistently exhibit higher volatility than stocks listed in developed markets. For example, over the trailing 10-year period through August 2016, the MSCI Emerging Markets Index's volatility was roughly 20% and 35% greater than the MSCI EAFE (foreign developed markets) and S&P 500, respectively. Despite this volatility, emerging-markets stocks offer diversification benefits, as the MSCI Emerging Markets Index is only 75% correlated to the S&P/TSX Composite Index.

This fund uses near full replication to track the market-cap-weighted MSCI Emerging Markets Index. This approach results in a portfolio that reflects the composition of the market, diversifies company-specific risk, and promotes low turnover. MSCI starts with all publicly available stocks listed in 23 emerging-markets countries. These stocks constitute the investable market universe. The index then sorts them on free-float-adjusted market capitalization and targets those representing the largest 85% of the investable universe by market capitalization, thereby eliminating small-cap stocks. The index applies additional screens for liquidity and foreign ownership eligibility to make it easier to track. This resulting index portfolio includes over 800 constituents. The fund's advisor then fully replicates the index to mimic its investment profile.

For a cheaper alternative to XEM within the iShares family, investors might consider

iShares Core MSCI Emerging Markets IMI ETF ( XEC ), which has a 0.26% expense ratio. It tracks an all-cap benchmark, giving it broader emerging markets exposure than XEM. Despite the similarities in its benchmarks, XEC is far cheaper, with a 0.26% MER. Investors who prize liquidity may find XEM more appealing, but XEC's low price tag make it a far better choice.

Like XEC, Vanguard FTSE Emerging Markets Index ETF ( VEE ) tracks an all-cap benchmark, but the index diverges by including China A-shares, which will eventually push its China weighting from the high 20s to low 30s. At 0.24%, its MER is a hair cheaper than XEC. Unlike FTSE, MSCI classifies South Korea as an emerging market, giving XEC a 12% stake in the country.