Where To Find ETF Innovation

Look to emerging markets.

Reviewed by: Dave Nadig
Edited by: Dave Nadig

[This article appears in our August 2019 issue of ETF Report.]

Amid the maelstrom of ETF launch activity (roughly 130 this year so far), I get asked the same question over and over again, from press, from issuers and from investors: Is there really any room left for innovation? Are there real opportunities?

For an answer, you need look no further than a handful of products in the emerging market (EM) space.

These innovations are timely: Emerging markets remain one of the great value plays in the global equity markets. With the U.S. equity markets sitting at an implied forward price-to-earnings ratio of a quite high 17.1 (according to Yardeni Research), and the MSCI All Country World Index (ACWI) sitting at 15.1, the forward P/E of the MSCI Emerging Markets Index is just 11.9. And that number doesn’t even reflect some of the true value pockets around the world: Russia’s sitting at a 5.5 forward P/E, Turkey at 6 and China at 11.

So if investors aren’t looking for EM exposure, they probably should be. Luckily, the past few years have brought us some of the most interesting funds to cover these bases I’ve seen in  a long time.

Freely Radical
Perhaps the boldest launch I’ve seen in years is the Alpha Architect Freedom 100 Emerging Market ETF (FRDM). The brainchild (and, it would seem, life’s work) of index provider Life + Liberty Indexes’ Perth Tolle, the fund selects and weights EM countries not by market capitalization or some smart beta factor, but based on five measurements of human freedom ranging from freedom of the press to the rule of law.

Tolle literally spent years working with nonprofits and think tanks as well as some of the smartest quant finance people in the business (notably Wes Grey from Alpha Architect, and Rob Arnott from Research Affiliates) to create a completely unique investable product that overweights the idea of freedom.

Or take the approach used by WisdomTree in its China ex-State-Owned Enterprises ETF (CXSE). This addresses the biggest problem with investing in China, which is getting to the “real China” as a U.S. investor.

While the fund launched years ago, it’s taken the trade war to really show this fund’s mettle, as it’s absolutely crushed competing approaches at the midway point in 2019. And the logic here is even simpler than FRDM: Skip the companies that are really just arms of the Chinese government so you can capture the growth of the Chinese consumer and the rising middle class.

The list of innovative funds that most investors haven’t heard of in the EM segment is long and impressive. The Cambria Emerging Shareholder Yield Fund (EYLD) uses a multifactor smart beta model to pick stocks, and is the best-performing broad market EM fund so far in 2019 (up 15.74% at July 1, versus 10.6% for the broad MSCI index).

The best-performing large cap EM fund? The Invesco RAFI Strategic Emerging Markets ETF (ISEM), which uses the Research Affiliates multifactor model to pick large emerging market companies. The best-performing China ETF this year? The fundamentally weighted KraneShares CICC China Leaders 100 Index ETF (KFYP).

Look Harder
Unfortunately, these funds are mostly tiny and unloved, receiving little investor attention. To me this is a shame. Everyone clamors for better products—ones that do something different, and do it well. And here they are.

Conventional wisdom for decades has been that the narrower and less-covered the asset class—whether it’s EM stocks or high-yield municipal bonds—the more opportunity there is to do “better than beta” just by tweaking your approach. The staggering and successful innovation we’ve seen in emerging markets is proving the conventional wisdom correct. Too bad more investors aren’t getting the memo.

Prior to becoming chief investment officer and director of research at ETF Trends, Dave Nadig was managing director of etf.com. Previously, he was director of ETFs at FactSet Research Systems. Before that, as managing director at BGI, Nadig helped design some of the first ETFs. As co-founder of Cerulli Associates, he conducted some of the earliest research on fee-only financial advisors and the rise of indexing.