To many investors, emerging markets are all about growth: tapping the burgeoning economies and rising wealth of consumers in China, India and other developing countries. But there’s another reason to invest in emerging markets these days: dividend income.
While emerging markets still offer growth, dividends now match or exceed levels in developed markets, according to a recent report from HSBC Bank. Yields are about 3% across emerging markets, beating the 2.2% yield on the S&P 500 (.SPX). And dividend yields have grown faster in the developing world, rising 8.3% a year on average from 2004 to 2011, compared to 4.8% in developed markets.
Dividends have an added benefit too: They offer an income stream that can help lower the risk and volatility of emerging market stocks, says Arjun Jayaraman, head of quantitative research for Causeway Capital and co-manager of the Causeway Emerging Markets Fund (CEMVX). Companies that pay regular dividends tend to have stable cash flows and predictable earnings, he says, and many are in sectors such as utilities and telecommunications, which tend to be less volatile than the market as a whole.
Of course, a high yield can be a red flag if a company isn’t earning enough to support the payments. If that’s the case, the dividend is likely to be cut, pressuring the stock.
Yet payout ratios — the share of profits a company pays out in a dividend — average about 30% in the developing world, according to HSBC, slightly below the average for developed markets. That should give many emerging-market firms room to boost their dividends if profits rise. And growth seems to be on the upswing.
Profits are forecast to grow 15% for companies in the MSCI Emerging Markets Index over the next 12 months, according to MSCI and Thomson Reuters, compared to 10.6% estimated growth for the S&P 500. The MSCI index also looks cheaper, trading at a forward P/E ratio of 10.3, a 24% discount to the S&P 500 at 13.5.
Mind the downside
While dividends can provide steady income, focusing on yield usually means giving up some growth, says Margaret Kalvar, an emerging markets stock analyst with fund company Harding Loevner, based in Bridgewater, N.J.
Most of the companies she covers don’t pay a dividend because they’re plowing cash back into the business, she says. And growth companies that do pay a dividend usually yield less than the market average.
Dividend payments also tend to be more stable in developed markets. Companies in the U.S., Europe and Japan are more reluctant to cut their dividends when earnings slump, according to HSBC. In emerging markets, dividends are more likely to be cut when earnings drop off.
Emerging markets are prone to big sell-offs, too: Investors tend to flee at the first sign of a financial or political crisis. And their volatile currencies add risk, says Sammy Simnegar, manager of the Fidelity Emerging Markets Fund (FEMKX).
If a stock yields 10% but has no growth, for instance, foreign currency losses of 10% could wipe out your returns, he notes. Rather than focus on high-yield names, he looks for companies with above-average growth, strong returns on capital and durable competitive advantages.
Because of these issues, most advisers recommend emerging markets for a small part of your stock portfolio, generally no more than 20%. ETFs or mutual funds may be the best way to invest: They can provide automatic diversification across regions and sectors, and you don’t have to worry about trying to pick stocks in far-flung, foreign markets.
Following are three ETFs and one dividend-focused mutual fund to consider, based on our research and interviews with analysts. Most of these funds pay out dividends as ordinary income, making them best held in a non-taxable account. However you invest, you should conduct your own research or consult an adviser before buying shares.
SPDR S&P Emerging Markets Dividend ETF
- Ticker: EDIV
- 30-day SEC yield: 5.4%
- Annual expense ratio: 0.59%
Offering one of the higher yields, the SPDR S&P Emerging Markets Dividend ETF (EDIV) may seem like a risky choice. Yet companies must have three years of positive earnings growth and profitability to be included in the ETF, which tracks the S&P Emerging Markets Dividend Opportunities Index. That gives it a “quality tilt,” according to Morningstar analyst Patricia Oey. Moreover, no stock accounts for more than 3.3% of its assets, keeping it broadly diversified.
Performance for the ETF’s index has been solid. Over the past decade, it beat the MSCI Emerging Markets Index by more than 2 percentage points a year, with a similar level of volatility, according to Morningstar.
The downside: Smaller markets such as Turkey and South Africa account for around 20% of its holdings, and the ETF could suffer if those markets sell off. The ETF also has 19% in utilities — a slow-growth sector that tends to fall when interest rates rise.
iShares Emerging Markets Dividend ETF
- Ticker: DVYE
- 30-day SEC yield: 5.6%
- Annual expense ratio: 0.49%
The iShares Emerging Markets Dividend ETF (DVYE) heads off the beaten path in search of high-yielding names. Tracking the Dow Jones Emerging Markets Select Dividend Index, the ETF’s top holdings include Polish miner KGHM Polska Miedz, Chinese sportswear maker Anta Sports Products and Turkish telecom company Turk Telekomunikasyon — none of which crack the top 10 in the more mainstream MSCI Emerging Markets Index.
While the ETF holds many smaller names, its underlying index has been less volatile than the MSCI index, according to Morningstar. And the ETF holds companies that have paid dividends annually over the past three years and grown earnings per share, providing a measure of support.
The downside: The ETF only launched last year and hasn’t proven itself in a bear market. Stocks in Taiwan and Brazil make up 43% of its holdings and could drag down returns if those markets fall.
WisdomTree Emerging Markets SmallCap Dividend Fund
- Ticker: DGS
- 30-day SEC yield: 4%
- Annual expense ratio: 0.64%
Many emerging-market ETFs focus on giant exporters like Russia’s Gazprom and Korea’s Samsung Electronics. If you want to tap more local-market growth trends, WisdomTree Emerging Markets SmallCap Dividend Fund (DGS) may be worth considering.
This ETF holds around 530 small-company stocks scattered throughout emerging markets. Top holdings include a Chilean pension fund administrator, a Hungarian telecom firm and a Polish electric utility. The ETF, based on a proprietary index developed by WisdomTree, weights stocks based on their annual cash dividends, and it’s broadly diversified, with no stock accounting for more than 1.5% of total assets.
Another positive: The ETF has a large exposure to consumer businesses and financial firms — companies that should benefit from rising domestic consumption in developing countries, notes Morningstar’s Oey. Moreover, emerging-market banks have strengthened their balance sheets in the last few years, putting them in a stronger financial position.
The downside: Small-cap stocks are risky and the ETF could see “steep declines” when global market volatility spikes, according to Oey. Long-term, though, the ETF has performed well, returning 6.9% annually over the past five years, beating the average emerging market fund by about 6 percentage points, according to Morningstar.
Matthews Asia Dividend Fund
- Ticker: MAPIX
- 30-day SEC Yield: 2.2%
- Annual expense ratio: 1.1%
Investors who want income usually give up some growth. But the folks running the Matthews Asia Dividend Fund (MAPIX) try to find both: They hold utilities and telecom stocks with stable cash flows and high yields, and they own faster growing consumer and industrial firms that don’t yield as much but have better potential for capital gains.
The mix has paid off: The fund climbed 10.3% a year on average over the last 5 years, beating 99% of funds in its category, according to Morningstar. It’s also 38% less volatile than the MSCI EAFE Growth Index, and it held up relatively well in 2008, falling 26% versus a 44% plunge for the MSCI emerging market index.
Lately, the fund has focused more on consumer discretionary and industrial stocks tied to improving economies across Asia, says co-manager Jesper Madsen. Many big dividend payers no longer have compelling prices, he says, while some “cyclical” stocks haven’t risen as much and offer better prospects.
The downside: The fund distributes ordinary income quarterly, making it best held in a non-taxable account. Its dividend-oriented strategy may lag in some markets. Overall, though, the fund has “excellent long-term prospects,” according to Morningstar analyst William Samuel Rocco, who rates it highly.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services. He does not own any of the securities mentioned in this article.