Value, Emerging Markets Will Continue to Win

With the exception of China, emerging markets continue to do well.. It's almost an article of faith on Wall Street that emerging markets are overdue for a fall. Citing the phenomenal performance of these markets over the past few years, and the fact that historically they have been very volatile, many strategists conclude that there must be a reversion to the mean, and therefore a nasty correction is coming.

Lucky readers who've doubled or tripled their money in emerging markets may want to take some profits to rebalance their portfolios, but we advise against abandoning the sector. The components of the iShares MSCI Emerging Markets Index(EEM Quote) still have a cheaper average P/E ratio than that of the constituents of the S&P 500, but it offers faster earnings growth.

I realize most would argue that emerging markets deserve a lower P/E ratio, but iShares MSCI Emerging Markets is composed of world-class competitors such as Samsung, many of which got to be that way by beating the pants off American (or Japanese) companies.

Further, the majority of stocks in this ETF are in the form of American depository receipts and thus are subject to the same accounting and disclosure requirements as, say, General Electric (GE Quote). We'd argue that Samsung's fortunes and the performance of its stock have more to do with worldwide demand for the company's products, and less to do with the fact that its headquarters are in Seoul.

One emerging-market fund we would avoid is iShares FTSE/Xinhua China 25 (FXI Quote), which is dominated by financial, telecom and energy firms, all of whose fortunes are tied to Chinese domestic demand.

While China's economy is growing at a blistering pace, iShares FTSE/Xinhua China 25 now trades at nearly 17 times estimated 2007 EPS, and expected 2007 growth for the fund is just 4%. That makes the fund more expensive and slower-growing than iShares MSCI Emerging Markets. It is also more risky, in our estimation, owing to its single-country focus and the lack of any internationally known companies in the fund.

Price-to-Earnings Ratio on 2007 EPS

Source: AltaVista Independent Research

Estimated 2007 Earnings Growth

Source: AltaVista Independent Research

Fundamental indexing proves its mettle. A lot of indexing gimmicks have been introduced over the past few years, but one innovation that has real value, in my opinion, is fundamental indexing. This strategy seeks to avoid the Achilles' heel of market-cap-weighted indices, which are by definition overweight stocks that later prove to be overvalued, and underweight stocks that later prove to be undervalued.

Although there are several approaches to fundamental indexing, I like the PowerShares FTSE RAFI 1000(PRF Quote), which weights about 1,000 large- and mid-cap stocks according to sales, earnings, dividends and book value. Though the ETF has existed for just over a year, the back-testing results for fundamental indexing I've seen are impressive -- and not just for this single diversified product but sliced and diced across sectors, market-cap segments and geographic regions, in both bull and bear markets.

It's real-world results that matter, however. Compared with the iShares Russell 1000 (IWB Quote) fund, which has, by and large, the same constituents, but is purely market-cap weighted, the PowerShares FTSE RAFI 1000 outperformed by over 3.0 percentage points last year. The difference in performance is more than enough to compensate for the difference in expenses between the two funds (the PowerShares FTSE RAFI 1000 has an expense ratio of 0.60% while the iShares Russell 1000 charges 0.15%).

Fundamental Indexing Proves Its Mettle PowerShares FTSE RAFI 1000 outperforms iShares Russell 1000

Note: Rebased, December 2005=100

I realize that one year of results is probably not enough to convince the skeptics, many of whom will maintain that it's too early to tell. But I believe the gap in performance between the PowerShares FTSE RAFI 1000 and the iShares Russell 1000 will continue to widen in 2007, proving the mettle of fundamental indexing. At any rate, I think the PowerShares FTSE RAFI 1000 could be an excellent choice for "set it and forget it" investors who seek to outperform the market over the long term by systematically avoiding market excesses.