What is FEM? (Pros, Cons, and Strategies)

If you're seeking to diversify your investment portfolio with exposure to emerging markets, FEM could be an option worth considering. FEM stands for First Trust Emerging Markets AlphaDEX Fund, and it seeks to provide a more structured approach to investing in emerging markets. Today, we'll explore what FEM is, its advantages, disadvantages, and strategies for investing in it.

What is FEM?

FEM is an exchange-traded fund (ETF) that aims to provide exposure to emerging market equities by using an enhanced indexing strategy. Specifically, FEM follows the NASDAQ AlphaDEX Emerging Markets Index, which aims to outperform traditional market-cap weighted indices by selecting stocks through a series of quantitative metrics.

Key Features of FEM

• Stock Selection: Uses a proprietary AlphaDEX methodology to select stocks based on fundamental growth factors, such as book value, cash flow, and sales growth.
• Geographic Diversification: Provides exposure to a wide range of emerging markets, including countries like China, India, and Brazil.
• Sector Diversification: Allocates investments across various sectors, such as technology, consumer discretionary, and financials.

The index selects stocks from a broader pool of emerging market equities and ranks them based on multiple factors to identify companies with strong growth potential and profitability.

FEM Composition

FEM is composed of equities from major emerging markets. Typical holdings might include companies from diverse sectors and countries. In contrast to traditional ETFs that follow market-cap weighted indices, FEM uses a scoring system to choose stocks, potentially identifying undervalued or over-performing sectors and companies. This scoring system includes factors like:

• Price Appreciation
• Earnings Consistency
• Sales Growth
• Liquidity Metrics

The ETF aims to balance between growth opportunities and risk management by diversifying its investments across various sectors and countries.

Pros of FEM

Diversification Across Emerging Markets

FEM provides a diversified exposure to multiple emerging markets, which can be a boon for investors looking to spread their risk. Because emerging markets can be volatile, having a structured and diversified investment vehicle helps in mitigating the impact of market-specific downturns.

Enhanced Stock Selection

The AlphaDEX methodology aims to pick stocks with strong fundamentals. This quantitative approach may help in outperforming more traditional index funds that simply follow market-cap weighting. Such a methodology can potentially identify undervalued or high-growth stocks that other indices might overlook.

High Growth Potential

Emerging markets often have higher growth potential compared to developed markets due to factors like younger populations, faster economic growth rates, and increasing consumer spending. This provides an upside for long-term investors who are willing to accept higher volatility.

Sector and Geographic Diversity

With investments spread across different sectors and geographic regions, FEM minimizes the risk associated with sector-specific or country-specific downturns. This diverse spread is crucial for maintaining a balanced portfolio.

Cons of FEM

High Volatility

Emerging markets are inherently more volatile compared to developed markets. Political instability, currency fluctuations, and changes in economic policies are more common, thus adding an extra layer of risk for investors.

Higher Expense Ratio

FEM has a higher expense ratio compared to some other ETFs, which can eat into your returns over the long term. The increased costs are due to the active stock selection methodology and frequent rebalancing required to maintain the AlphaDEX strategy.

Currency Risk

Investing in foreign markets introduces currency risk, especially in emerging economies where currencies can be more volatile. Currency fluctuations can impact the returns on your investment either positively or negatively.

Limited Track Record

Emerging markets and the methodologies for selecting stocks therein are relatively new and lack the long historical track record found in more established markets. This makes predictive performance less certain.

FEM Investment Strategies

Investing in FEM requires a thoughtful strategy due to its unique characteristics and inherent risks. Below, we outline practical investment strategies tailored for different types of investors.

Long-term Buy and Hold Strategy

Given the high volatility and growth potential of emerging markets, a long-term buy and hold strategy can be effective. By committing to a long-term horizon of at least 10 years, investors can smooth out short-term fluctuations and benefit from the overall growth trends in emerging economies.

With FEM, this strategy involves:

• Regular investments over time to take advantage of dollar-cost averaging.
• Reinvesting dividends and distributions to maximize the compound effect.

Diversification Strategy

It's essential not to put all your eggs in one basket. FEM is an excellent tool for diversifying your portfolio by adding international exposure. However, it should be balanced with investments in developed markets and other asset classes like bonds and commodities to mitigate risk.

Active Monitoring

While FEM employs a smart strategy for stock selection, actively monitoring your investment can help you make timely decisions based on market conditions. Keeping abreast of global news, economic indicators, and regional market performances can offer insights into when to adjust your holdings.

Risk Management Strategy

Given the high potential for volatility, employing risk management techniques is crucial. This includes:

• Setting stop-loss orders or alert levels to minimize losses.
• Allocating a portion of your portfolio to low-risk assets to balance the risks.

In conclusion, FEM offers a unique and structured approach to investing in emerging markets. Its advantages lie in its diversified exposure and enhanced stock selection methodology. However, investors should be aware of its higher volatility, expense ratio, and associated risks. By employing thoughtful strategies and maintaining a long-term perspective, FEM can be a valuable addition to a diversified investment portfolio.