Using ETFS To Trade Emerging And Developed Markets

By Casey Murphy | September 02, 2014 AAA

When it comes to financial performance, there is a built in tradeoff between risk and reward. Generally speaking, higher returns are gained by increasing one's exposure to risk. This is why most traders would expect a diversified portfolio in equities to outperform the returns of a series of GICs from their local bank.  For a quick refresher on this topic, check out Financial Concepts: The Risk/Return Tradeoff.

Looking To Emerging Markets For Growth

Over the past several years, many investors seeking higher-than-average returns have been enticed to consider investing in emerging markets. These are the countries that are experiencing, or are expected to experience, a burst in business activity and/or industrialization. Countries such as Brazil, Russia, India and China are often considered the leading emerging markets in the world.

Unfortunately, the Great Recession has hampered the economic prosperity of the emerging markets and many of these nations are rebounding more slowly than anticipated. According to the International Monetary fund, “The global recovery is becoming broader, but the changing external environment poses new challenges to emerging market and developing economies.”

In a recent report, the IMF reported that “Tighter financial conditions and the resulting higher cost of capital could lead to larger-than-projected slowdown in investment and durables consumption in emerging markets, and thereby weigh on growth.”

A Developing Surprise

As you can see from the chart below, the developed nations, as measured by the iShares MSCI EAFE Index Fund (NYSE:EFA), Vanguard FTSE Developed Markets ETF (NYSE:VEA) and the WisdomTree Japan Hedged Equity ETF (NYSE:DXJ) have outperformed the emerging market nations as measured by the Vanguard Emerging Markets Stock Index ETF (NYSE:VWO), iShares MSCI Emerging Markets ETF (NYSE:EEM) and Market Vectors Russia ETF (NYSE:RSX).

As you can see from the chart below, the developed nations, as measured by the iShares MSCI EAFE Index Fund (NYSE:EFA),

For many traders this outperformance may seem counterintuitive, but the charts of the various ETFs clearly suggest that capital is continuing to flow into the developed markets and away from emerging markets. Armed with this information, it would be prudent to adjust trading strategies accordingly.

For traders, it appears there are two different ways to trade this strong divergence. If one believes the emerging markets will be slow to rebound, as the IMF suggests, then a shortlist should be created out of the developed market ETFs. On the other hand, if a trader believes the divergence will tighten over the remaining part of the year then a pairs trade would be appropriate using the ETFs listed above as a starting point. For more, check out Pairs Trading: Introduction.

A Look At The Charts

The strong uptrend in developed markets is best shown by the chart of the iShares MSCI EAFE Index Fund. This is the most common ETF for trading the developed markets based on assets. For long-term traders, it is interesting to note that there are several key levels of support nearby that should prop the price up in case of any short-term selling pressure. Notice how the 200-day moving average (shown by the red line) has acted as a strong zone of support in the past. Position traders would want to protect their positions by placing a stop-loss just below $63.94. The chart of the Vanguard FTSE Developed Markets ETF looks nearly identical to that of EFA so we won’t show it here, but for those looking to protect a position in VEA, look to place a stop-loss near $39.30.

The strong uptrend in developed markets is best shown by the chart of the iShares MSCI EAFE Index Fund.

The downward pressure in the emerging markets is nicely shown on the chart of Vanguard Emerging Markets ETF. This is the most common emerging markets ETF based on assets and is a good example of how a long-term descending trendline can act as a barrier to a move higher. Notice how the price has failed to move above the trendline on several occasions in the past (shown by the red arrows). Traders would not expect a reversal of the downtrend until the price is able to close above the identified trendline. The charts of the other emerging markets also look very similar to VWO so they are not covered here. 

The downward pressure in the emerging markets is nicely shown on the chart of Vanguard Emerging Markets ETF.

The Bottom Line

The inverse correlation between the developing markets and the emerging markets suggests that it is not worth the extra risk of investing in emerging markets such as Rusia, India and China. Until the long-term trends, which were identified on the charts are reversed, traders would expect the developing markets such as Japan, Germany, Australia and the United Kingdom to outperform. 

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