How Best to Play the Emerging Markets Rally If You Dare

Emerging markets have had a rough time of late. And it has been more than just a tough year or two years.

The hottest asset class of the 1990s has been underperforming a simple “dumb and long” strategy of investing in the S&P 500 for more than a decade.

I wrote about my skepticism about investing in emerging markets in March.

Emerging markets had disappointed investors o such a degree over time that any short-term rally was to be taken with a grain of salt.

A quick glance at the chart comparing the MSCI Emerging Markets Index to the S&P 500 during the past five years confirms why.

MSCI Emerging Markets Index to the S&P 500 over 5 years

The biggest news is that commodities have rallied, propelling the stock markets of Latin American countries to some eye-popping gains. The iShares MSCI All Peru Capped ETF (EPU) has rallied 65.3%, and iShares MSCI Brazil Capped ETF (EWZ) has soared 58.82%, despite the country’s constant state of political crisis and uncertainty surrounding the Olympics. Even perennial bad boy Russia — through the VanEck Vectors Russia ETF (RSX) — is up 26.14%.

By way of comparison, the overall MSCI Emerging Markets Index (EEM) is up by a less impressive 13.70%.

Still, this is the first time in many years that a broad bet on emerging markets is outpacing the S&P 500.

A Set of Outperforming Strategies

As part of the daily market analysis for my trading services, I track a large number of competing investment strategies across a wide range of asset classes, including emerging markets.

And I was pleasantly surprised when a handful of emerging markets strategies popped up on my investing screens that were handily trouncing the mainstream index year to date.

I was also struck by how many of these strategies had generated double-digit percentage gains during the past month alone.

This kind of a move in emerging markets, while not unprecedented, certainly caught my eye.

After studying the underlying investment strategies, I saw two themes driving this strong outperformance.

1. Fundamental Value Screens

The MSCI Emerging Markets Index is a classic market-cap weighted index. The bigger the free float of the company, the bigger its weight in the exchange-traded fund (ETF).

The top-performing emerging markets strategies of 2016 are taking a very different tack.

The PowerShares FTSE RAFI Emerging Markets ETF (PXH) and Schwab Fundamental Emerging Markets Large Company ETF (FNDE) — each up roughly 25% — screen for stocks based on traditional valuation metrics.

And for the first time in many years, they have been rewarded with strong outperformance.

After many years where fundamental valuation seemed irrelevant in emerging markets investing, could this be a sign of a return to “normalcy?”

Five months of relative outperformance is not long enough to draw a conclusion.

But there is a glimmer of hope.

2. High Dividend-Paying Stocks

In a world where investors are starved for cash-generating investments, it is no wonder that high-dividend stocks in the United States — as epitomized by the Dividend Aristocrats and Dividend Dogs — have been among the U.S. stock market’s strongest performers.

As it turns out, emerging market strategies that invest in high dividend stocks have also been the belles at the performance ball of late.

No fewer than three dividend-focused emerging markets ETFs have generated roughly 20% total returns this year: SPDR S&P Emerging Markets Dividend ETF (EDIV), ALPS Emerging Sector Dividend Dogs ETF (EDOG) and WisdomTree Emerging Markets High Div ETF (DEM).

In emerging markets, as elsewhere in the world, cash is king.

So are emerging markets, the red-hot asset class of the late 1990s, back?

It is far too early to say.

But it is clear that these two alternative strategies, fundamental valuation and high dividends, are driving substantial outperformance compared to mainstream, market-cap-weighted emerging markets indices so far in 2016.

And after close to a decade of underperformance, that is a welcome development, indeed.

In case you missed it, I encourage you to read my e-letter column from last week about the latest trends in machine learning and virtual reality. I also invite you to comment in the space provided below.