6. Regional Equity Exchange-Traded Funds

Country-specific idiosyncratic risk (called also specific risk, unsystematic risk, or residual risk), analogous to firm-specific idiosyncratic risk, is the risk specific to an individual country that can be reduced or eliminated through diversification.

All data as of end of February 2020.

Correlations measured using MSCI country or regional indexes.

Regions as defined by MSCI.

All data as of end of February 2020.

Overconcentration is also a significant problem in some single-country equity indexes; however, they use capping to ensure diversification among companies, and to the lesser extent to sectors.

An interesting, and simultaneously an untypical example of capping is the MSCI EFM Africa Capped + GCC Countries Capped Special Weighted 10/40 Index. To avoid excess concentration, the weight of each country is first capped in two component indexes (the maximum weight of any country is limited to 70%), following which, the composite index is capped as per the MSCI 10/40 Indexes methodology (this methodology will be explained in the next chapter).

All the above aspects of international equity investing were described in Chapter 5.

Classifications of countries are made by various international institutions (e.g., International Monetary Fund), but from the point of view of passive investing, the most important are classifications made by index providers.

Quantitative and qualitative factors may vary between index providers. For example, the quantitative criteria applied by the S&P Dow Jones Indices cover a range of factors that reflect macroeconomic conditions (e.g., GDP per capita, non-occurrence of hyperinflation), and capital market development (e.g., minimum full domestic market capitalization, domestic turnover value, and exchange development ratio). Qualitative criteria include factors such as political stability, investment conditions (e.g., no significant foreign ownership restrictions and freely traded foreign currency), legal property rights and procedures, and trading and settlement processes. Final decisions on classification are made by the S&P Dow Jones Indices Global Equity Index Committee based on both the consultation and the quantitative criteria (S&P Dow Jones Indices 2019).

FTSE Russell additionally divides emerging countries in two subcategories: advanced emerging and secondary emerging.

World Bank data as of 2018.

Although advanced economies and emerging economies grew at about the same pace at 1980s and 1990s, the GDP growth rates in the 2000s and 2010s in the former were significantly lower. The growth gap between the two economies increased, particularly in 2000s, peaking at 6.1 pp in 2009, then it declined and stabilized at 3 pp over the past decade. It is also worth noting that though economic growth rates in recent years were much lower for DMs than EMs, the former also showed lower levels of dispersion in growth rates (European countries and Japan developed most slowly). A detailed trend analysis of global economic activity and global trade broken down into developed and emerging countries in the last three decades is presented by MSCI (2019).

In regional terms, EMEA and Pacific countries outperformed North America in the run-up to the financial crisis in 2008, but considerably underperformed North America after the crisis. Eventually, North American countries delivered the highest, and Pacific countries the lowest levels of returns during the whole period.

MSCI Emerging Markets Index vs. MSCI World Index.

It should be emphasized that developed markets perform much better against emerging markets when considering real (i.e., inflation-adjusted) returns, as nominal returns are often greatly devalued by high inflation on the latter.

The MSCI World Index captures large- and mid-cap representation across 23 developed markets. The MSCI World ex USA Index captures large- and mid-cap representation across 22 out of 23 developed markets, excluding the USA. Both indexes cover approximately 85% of the free float-adjusted market capitalization in each country.

The underperformance of emerging markets in USD terms was also partly explained by currency effects, as EM currencies underperformed both USD and other DM currencies.

The divergences would be even greater if all developed countries were included. According to Dimensional Fund Advisors (2019), the difference between the best and worst performers among developed markets over the last 20 years (1999–2018) ranged from as low of 24 percentage points in 2018 (Finland −3% and Austria −27%) to as much as 81 percentage points in 2009 (Norway 87% and Japan 6%).

North American countries experienced the lowest levels of risk among developed countries, and Pacific countries the highest (except maximum drawdown).

However, there were considerable disparities between the regions. The Sharpe ratio for North American countries was 0.49, while for EMEA countries it was 0.27, and −0.03 for Pacific countries.

This study is based on the Janus Henderson Global Dividend Index (JHGDI). The JHGDI measures the progress global firms are making in paying their investors an income on their capital. It analyzes dividends paid by the world’s largest 1200 firms by market capitalization (representing 90% of global dividends paid); dividends paid by the next 1800 firms are estimated. The index is calculated in USD, and its base year is 2009. It is broken down into regions, countries, industries, and sectors.

Underlying dividend growth is headline dividend growth (change in total gross dividends) adjusted for special dividends change in currency, timing effects and index changes.

As of the end of the first quarter 2018.

According to CLSA data, over 80% of companies from DMs have paid dividends in the last 20 years (1998–2017), while in the case of EMs, this percentage has only recently reached this level (Su 2018).

As of August 31, 2019.

Generally, there are two methods of dividend investing. The first one, known as high dividend-yielding equities, relies on investing in companies with above-average dividend yields. The second approach, known as dividend growth-oriented equities, assumes investing in companies that have a history of maintaining or increasing their dividends (though they usually tend to yield less than global broad market equities) (Schlanger and Kesidis 2017). In the case of passive investing, the requirements for dividend growth index inclusion (on an example S&P Dow Jones Indices) range—depending on the market/region—from five years (Canada) to even 20 years (USA). According to S&P DJI research, foreign (i.e., outside the USA) dividend growth-oriented stocks generally offer higher yields and higher dividend growth, and they outperform in the long run (Cheng et al. 2019).

It is worth adding that high-dividend stocks have different characteristics compared to low-dividend stocks. Usually, they tend to be more mature firms, with conservative management. Systematically investing in stocks which pay a high dividend is an effective way to reduce volatility, while at the same time enhancing returns.

The MSCI World High Dividend Yield Index is based on the MSCI World Index and includes large-cap and mid-cap stocks across 23 developed markets. The index is designed to reflect the performance of equities in the parent index with higher dividend income and quality characteristics than average dividend yields that are both sustainable and persistent. It also applies quality screens and reviews 12-month past performance to omit stocks with potentially deteriorating fundamentals that could force them to cut or reduce dividends.

More on this in the next section.

High dividend-yielding equities from DMs represented by MSCI World High Dividend Yield Index, and “normal” DMs equities represented by MSCI World Index.

There are many different versions of these indicators, as well as many other ratios, but these issues are not the subject of the book and will not be discussed.

Valuations (P/BV) of stocks from developed markets have fallen relative to emerging markets until 2010 (with the exception of the crisis) but have been systematically growing since then.

P/E ratios of stocks from developed markets (relative to emerging markets) grew suddenly from 1999 to 2001, then fell gradually until 2008, grew again until 2014, and have remained relatively stable in the last few years.

A similar degree of differentiation between countries occurred in other indicators.

Assets of equity exchange-traded products with exposure to broad DMs amounted to USD 707 billion at the end of 2019, which accounted for 14.5% of total assets invested globally in equity ETPs (BlackRock 2020).

International sector funds and thematic international equity ETFs, including those with regional exposure, will be described in Chapter 8.

Information on these sources is also available in the references at the end of Chapters 3–8.

All data as of the end of 2019.

Sector definitions in accordance with the GICS classification, applied by the S&P Dow Jones Indices and MSCI.

Various aspects related to country, sectoral, and company concentration of equity indexes are outlined in detail in Chapter 5.

The MSCI World Index was the first international performance benchmark designed to track the world’s developed markets. It was created in 1968 by Capital International, the Swiss subsidiary of the Capital Group (base date is January 1, 1970). The rights to the index were acquired by Morgan Stanley in 1986 (Shilling 2018).

According to PwC research (2019), the MSCI World Index was an underlying index in 123 EU-domiciled ETFs with EUR 73.5bn in assets as of the end of June 2019.

It should be remembered that some terms used in the names of equity indexes and, consequently, in ETFs offered (mainly on the US market) can be misleading, as they suggest global investing. This applies to term “world,” which refers only to developed markets, and the term “international,” which refers to developed markets ex-USA.

MSCI Kokusai Index (also known as the MSCI World ex Japan Index) captures large-cap and mid-cap representation across developed markets excluding Japan.

They will be described later in this chapter.

This index is designed to remove from index performance the impact of changes to the value of foreign currencies relative to the US dollar with a hedge ratio ranging from 0 to 100% on a monthly basis.

The term “emerging markets” was coined by Antoine van Agtmael in 1981 when he was working for the International Finance Corporation (IFC), a division of the World Bank. This term was to more positively describe countries previously referred to as “third world,” suggesting their progress, uplift, and dynamism.

World Bank data as of 2018.

Interestingly, share of EM countries in total equity market capitalization is more than 10 pp higher than share in free-float market capitalization—according to MSCI (2019) it amounted 23.4% as of end of February 2019.

It is worth noting that for some of these parameters, emerging markets—as a whole—dominate the world. For example, they represent 68% of the world’s population. Additionally, the seven largest emerging markets (Brazil, China, India, Indonesia, Mexico, Russia, and Turkey) accounted for 92% of the increase in metals consumption, 67% of the increase in energy consumption, and 39% of the increase in global food consumption over the past two decades (Baffes et al. 2018).

Interestingly, the average difference in the 2010s (63.7 pp) was almost half smaller than in the 2000s (122.2 pp). All data refer to differences in annual returns (in USD) between best and worst country equity index across emerging markets in the period 2000–2019.

Additionally, as we showed earlier, the effectiveness of diversification when investing in emerging markets is potentially higher, as average pairwise country correlations within EMs are distinctly lower than in DMs.

However, this is not the case over a much longer period. Research carried out by Dimson et al. (2019) demonstrated that emerging markets have underperformed developed markets since 1900—the annualized return from a 119-year investment in EMs was 1 pp lower than in DMs (7.2% vs. 8.2%).

All analyses are based on the MSCI World and MSCI Emerging Markets indexes’ returns.

Basic information on the strategy of investing in dividend companies was described in the previous section.

According to Janus Henderson data, the total value of dividends in emerging markets in the 2010s ranged from USD 87bn in 2010 to USD 140bn in 2019 (in percentage terms—from 8.6% of total dividends in 2016 to 14.0% in 2013).

The golden rule in investing in dividend stocks is to systematically monitor them and apply multiple screens to avoid the dividend trap. Unfortunately, often a rise in a share’s yield is a function of its falling price. That may be a sign that a company is in danger of cutting its payouts, or that it is unlikely to grow its payouts further from their already high levels. The investor’s goal should, therefore, be to identify companies trading at low valuations which have the ability to deliver not only solid yield today, but which also have underlying growth and stability in cash flows to grow that income into the future.

Assets of equity exchange-traded products with exposure to broad emerging markets equaled USD 251 billion at the end of 2019, which accounted for nearly 5.15% of total assets invested globally in equity ETPs (BlackRock 2020).

Melas (2019) presents detailed information on this index and its history.

Many critics argue that broad equity EM indexes are structurally biased toward larger markets and larger companies, and thus investors miss out on some of the best investment opportunities in this asset class which are often in smaller countries and small-caps (Stevenson and Tuckwell 2019). More information on investment advantages offered by the international small-caps segment can be found in, e.g., Orzano and Welling (2017), Brzenk and Du (2019) and Bender et al. (2012).

The weight of Chinese equities listed in mainland China and Hong Kong will grow to over 40% of the MSCI Emerging Markets Index, when A shares will be included at full weight.

There are EM equity indexes that apply restrictions to weights of countries. An example is the MSCI Emerging Markets Equal Country Weighted Index that includes the same constituents as its parent index (MSCI EM Index) but applies an equal country weighting at each semi-annual index review date.

All data as of end of 2019.

One of the MSCI Emerging Markets Index variants provides equal weights for all sectors. The MSCI Emerging Markets Equal Sector Weighted Index includes the same constituents as its parent index but applies an equal sector weighting across the GICS sectors at each semi-annual index review date.

Data as of the beginning of 2019.

This does not only apply to ETF sponsors, but also to other financial products providers. According to MSCI data over USD 1.8 trillion in AUM was benchmarked globally to the MSCI Emerging Markets Index suite as of June 30, 2018 (MSCI 2018). In turn in Europe, MSCI Emerging Markets Index was an underlying benchmark in 46 ETFs with EUR 31.4bn in assets (giving way only to S&P 500, MSCI World, Euro Stoxx 50 and STOXX Europe 50 indexes) as of end June 2019 (PwC 2019).

An untypical EM equity listed in the USA is Innovator MSCI Emerging Markets Power Buffer ETF. It aims to track the price return of the MSCI Emerging Markets Index, up to a predetermined cap, while buffering investors against the first 15% of losses over the outcome period.

Sometimes it is dictated by the desire to exclude a particular country from the investment spectrum, when we are convinced that the economic and investment prospects of this country are significantly worse than other countries.

State-owned enterprises are defined as government ownership of more than 20% of a company’s outstanding shares.

One of the most interesting is Freedom 100 Emerging Markets ETF that seeks to invest in countries that support life, liberty, and property rights (its methodology results in an emerging market ETF that’s vastly different under the hood from competing funds).

For example, the MSCI Emerging Markets (EM) Equal Weighted Index in which all constituents are weighted equally, effectively removing the influence of each constituent’s current price.

The term “frontier markets” was first introduced by the International Finance Corporation (IFC) in 1992 to refer to a subset of smaller markets within its emerging markets database that had lower levels of market capitalization and less liquidity.

There is less agreement between index providers as to what constitutes a frontier market compared to developed market and emerging market classifications. Other entities classify frontier markets even more differently—e.g., Credit Suisse includes 30 countries in this group.

World Bank data as of 2018.

Jamaica, Panama, Trinidad & Tobago, Bosnia Herzegovina, Bulgaria, Malta, Iceland, Ukraine, Botswana, Zimbabwe, and Palestine. The MSCI Standalone Market Indexes are not included in the MSCI Emerging Markets Index or MSCI Frontier Markets Index. However, these indexes use either the EM or the FM methodological criteria concerning size and liquidity.

Malawi, Palestine, Rwanda, Tanzania, Uganda, Ukraine, and Zimbabwe.

Major global equity indexes, as presented in Chapter 5, omit frontier markets and include only developed and emerging markets.

All data as of 2018. It is worth adding that, at that time, frontier markets also included, e.g., Kuwait and Saudi Arabia, which are now classified by most index providers as emerging markets. Thus, the current importance of FMs may be even smaller.

Let us note that almost all financial markets were once considered frontier markets prior to economic reforms, developing infrastructure, and building platforms and regulations for share trading. This applies to China, for example, which was widely considered a frontier market as recently as 1980. Today it is the second largest economy in the world.

These projections do not take account of major events since the date of the report, including, in particular, the global COVID-19 pandemic. Additionally, one must not forget the problems that have afflicted once highly promising countries, such as Argentina, Nigeria, Venezuela, and Zimbabwe.

The latest detailed data on economic growth are available in the World Bank (2020). However, it is worth remembering, that these prospects were developed before the outbreak of the coronavirus pandemic.

Frontier markets are a heterogenous group of countries in terms of economic growth rate. Based on IMF projections up to 2021, some of these countries (Côte d’Ivoire, Bangladesh, Kenya, and Vietnam) are on course for impressive development. Meanwhile, several other markets—mostly in Latin America and EMEA—will likely underperform in growth terms, compared to developed economies.

There are two potential explanations for frontier markets’ less volatile returns (expressed in USD). First, currency can have a significant impact on the volatility realized. Since FM currencies are not as free-floating as their more developed counterparts (they often closely follow the US dollar or other major currencies), it reduces the realized volatility. A second explanation may be lower cross correlations between countries (as will be shown later) (Philips and Redding 2013).

The average correlation to the S&P 500 Index, calculated monthly on a 60-month rolling basis, was even smaller (0.43), offering more diversification potential for US investors (Quisenberry 2018).

Calculations concerning the investment characteristics of frontier, emerging and developed markets are based on the MSCI Frontier Markets Index (USD), the MSCI Emerging Markets Index (USD), and the MSCI World Index (USD), respectively.

Similar conclusions can be drawn from previous studies conducted by MSCI (Maloor 2012) and Vanguard (Philips and Redding 2013) for earlier periods, although specific values may vary.

Frontier markets in this research were represented by a group of the ten largest countries within FMs selected by their respective ranking of current nominal GDP, population and equity market capitalization. This group included Argentina, Bangladesh, Egypt, Iran, Kenya, Morocco, Nigeria, Pakistan, Romania, and Vietnam. They collectively represented between three-quarters and four-fifths of the total economic, demographic, and equity investment opportunity set of frontier markets.

Standard & Poor’s launched the first frontier index (S&P Select Frontier) in October 2007, closely followed by the launch of the MSCI Frontier Markets Index in December 2007.

All data regarding indexes and ETFs as of mid-February 2020.

It is also worth mentioning the two ETFs that combine exposure to both emerging and frontier markets. The Global X MSCI Next Emerging & Frontier ETF seeks to provide investment results that correspond generally to the price and yield performance of the MSCI Select Emerging and Frontier Markets Access Index. The index aims to represent the performance of 200 securities from selected countries within the MSCI Emerging and Frontier Markets Indexes, i.e., 150 from EMs and 50 from FMs, while excluding the more developed EMs of Brazil, Russia, India, China, South Korea, and Taiwan. Meanwhile, the Xtrackers MSCI Africa Top 50 Swap UCITS ETF aims to track the MSCI EFM Africa Top 50 Capped TRN Index. The index provides exposure to 50 selected stocks from emerging and frontier African countries.

All data as of March 31, 2020.

This issue in relation to single-country ETFs will be discussed in Chapter 7.

The major index providers calculate many versions of this type of index. However, due to the limited size of this book, we will not discuss them in greater detail.

The huge number of these instruments and their providers makes it impossible to characterize them more accurately. Only the most important regional equity indexes will be listed.

More information on the European ETF market can be found, e.g., in Bioy et al. (2019), and Marszk and Lechman (2019).

There were EU-domiciled 91 ETFs with EUR 37.2bn AUM that mirrored this index at the end of June 2019 (PwC 2019).

Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Norway, Poland, Portugal, Spain, Sweden, Switzerland, and the UK.

There are also ETFs tracking MSCI EM Eastern Europe ex Russia Index that excludes Russian stocks.

For these types of indexes, their constituents are usually stocks only from developed markets or only from emerging markets.

It should be emphasized that these indexes do not have to include all countries that belong to a given alliance. For example, the MSCI EMU Index captures only 10 developed countries from all 19 members of the EMU.

There were 13 providers offering ETFs that tracked the performance of this index in 2019 (Bioy et al. 2019). AUM in 59 EU-domiciled ETFs that replicate it amounted to EUR 46.6bn at the end of June 2019 (PwC 2019).

Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands and Spain.

Austria, Belgium, Finland, France, Germany, Ireland, Italy, the Netherlands, Portugal and Spain.