May 23, 2012

Experienced investors recognize the benefits of owning a globally diversified portfolio.  But when it comes to choosing the right vehicles for getting exposure to emerging market equities, things can get complicated.  This segment of the global markets is notoriously volatile, and getting in at the wrong time or with the wrong fund can wreak havoc with your overall portfolio returns.

One way to mitigate the volatility issue is to look for funds that have demonstrated an ability to limit downside risk while still participating in the upside gains.  To do that, I looked at 3 years of monthly return data for the emerging markets, using the MSCI Emerging Markets Index as my benchmark.

I divided the 36 monthly observations into two groups – those with positive returns, and those with negative returns.  I then did the same thing for ETFs that claim to offer exposure to emerging market equities.

I wanted to find out which ETFs held up well during down months, and which ones outperformed during up months.  For example, if the benchmark index was up 1% in a given month, and the ETF was up 1.2% that month, I gave the ETF a score of 120, meaning that it captured 120% of the upside move in the index.  If the benchmark was down 1%, but the ETF was only down .8%, I gave the ETF a score of 80, meaning that the ETF captured 80% of the downside move.

Each investor has to decide which is more important – upside participation, or downside protection.  The best ETFs are the ones that can do both well.

Below are the scores for the benchmark index (EM), and 4 ETFs that are liquid, relatively low-cost, and widely held.

 

 

As you can see, these ETFs have very different behavior characteristics relative to the benchmark.  If you want to maximize your participation in the upside of the index, then EEM is your choice.  If you are more concerned about limiting your exposure to downside risk, then DEM would be a better choice.  And for the best overall combination of upside and downside performance, DEM looks like the winner.

*SCHE only has 2 years of data

Disclosure:  Mr. Conley does not have a position in any of the securities mentioned in this article.

About the author 

Erik Conley

Former head of equity trading, Northern Trust Bank, Chicago. Teacher, trainer, mentor, market historian, and perpetual student of all things related to the stock market and excellence in investing.

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