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Index IDEA: Different roads lead to emerging market exposure

Emerging markets have had a significant run in 2017, outperforming most developed global equity markets, yet we’ve seen a nearly 5% difference between two indexes tracking these markets year-to-date through July 31.

The Russell RAFI Emerging Markets Index’s return was 18.5% through July 31, while the FTSE Emerging incl Korea Index’s return was 23.2% for the same time period.

According to experts from Schwab ETFs and FTSE Russell, this difference isn’t a typo but rather stems from the different methodologies these two indexes follow, and speaks to the value of using both index approaches in the context of a long-term investment portfolio.

“The FTSE Emerging incl Korea Index weights its constituents purely by market capitalization, so its performance is a reflection of prevailing prices for emerging markets stocks and not their intrinsic value, said FTSE Russell managing director of North America research Rolf Agather. “The Russell RAFI Emerging Markets Index, on the other hand, uses a fundamental weighting approach which weights index constituents according to their intrinsic value, derived from sales, cash flow and dividend accounting measures, and not on price. For this reason, it is not difficult to see how a market cap weighted emerging markets index has had higher returns in 2017 amid heightened investor interest and stock valuations in this region.”

Does this mean that market cap weighted indexes are a better approach for investors?

“We believe an investment approach that combines market cap weighted and fundamentally weighted index approaches makes sense over time,” said Tony Davidow, Alternative Beta and Asset Allocation Strategist for The Schwab Center for Financial Research. “In fact, the fundamentally weighted Russell RAFI Emerging Markets Index was up nearly 30% in 2016, significantly outperforming its market cap weighted counterpart, and has had stronger aggregate performance over the last 5 years. The point is not which index methodology outperforms the other, but rather we believe that a blend of traditional and fundamentally weighted index-based approaches over time can help provide diversification, cost effective exposure and the potential for alpha.”

For more information on market cap and alternatively weighted indexes from FTSE Russell, go to the FTSE Russell website.

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Views expressed by Rolf Agather and Tony Davidow are as of September 6th and subject to change. These views do not necessarily reflect the opinion of FTSE Russell or the LSE Group.

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