Historically, most U.S. investors steered the vast majority of their equity holdings into domestic stocks, shying away from emerging markets because of their “excessive” volatility. But over the last few years, U.S. markets have experienced unprecedented turbulence and a prolonged downturn while many emerging markets have proved to be surprisingly resilient in the face of a global economic crisis. This seemingly sudden volatility of domestic stocks has many investors reevaluating their equity allocation and scrambling to understand a new risk paradigm.
The performance of the U.S. equity markets has more closely resembled a developing, volatile economy, as opposed to a stable global superpower. “Investors in the U.S. equity markets have lost half of their portfolios twice in a ten year period,” says Richard Kang, chief investment officer at New York-based Emerging Global Advisors (EGA). “To me, that sounds like the volatility one would find from an emerging market. But it happened in the U.S.”
New World Order
Many emerging Asian markets are expected to follow the lead of Australia and begin raising interest rates over the next quarter, months before the U.S. Federal Reserve is expected to consider easing off the stimulus pedal. This reordering represents a sharp departure from the traditional sequence of events, which has historically seen Asian central banks follow the lead of the U.S. The implication is crystal clear: Asia, particularly emerging Asia, will lead the U.S. and the rest of the developed world out of this global recession.
Between the beginning of 2008 and the bear market lows in March 2009, emerging markets, as tracked by the iShares MSCI Emerging Markets Index Fund (EEM), lost about 500 basis points more than U.S. equity markets, as measured by the iShares Russell 3000 Index Fund (IWV). But since bottoming out, emerging markets have experienced a much stronger recovery, gaining more than 90% over the last 6 months.
|Jan. 1, 2008 – March 9, 2009||-58.7%||-53.5%|
|March 9, 2009 – Oct. 6, 2009||90.3%||57.9%|
The misconceptions over investments in emerging markets are numerous. Many investors believe that emerging markets are destined to remain between developing and developed status indefinitely. While some economies struggle to implement effective market reforms and languish at “emerging” status for decades (such as Mexico), there are some noticeable success stories as well. Following World War II, Japan and Germany were classified as emerging markets. Today, these countries are home to the world’s second and fourth largest economies, respectively.
More recently, South Korea, home to one of the most developed technology sectors in the world, graduated from emerging status. The BRIC economies of Brazil, Russia, India, and China are home to some of the world’s largest countries and responsible for a significant portion of global GDP growth over the last decade.
Deficient U.S. Portfolios
As it becomes clear the the U.S. won’t lead this global recovery, many investors are questioning the traditional wisdom of limiting or avoiding exposure to emerging markets. “It’s shocking that there are so many institutional investors that have zero exposure to emerging markets,” says Kang, one of a growing number who believes most U.S. investors are underexposed to emerging market equities.
Legendary investor and author Burton Malkiel, now the chief investment officer at AlphaShares, is perhaps the most visible figure in this group. Malkiel has repeatedly lamented that most investors avoid Chinese equities completely, and those who do invest miss out on the “real China” by grabbing only a handful of mega-cap stocks. Investors who heeded Malkiel’s advice have been handsomely rewarded during the recovery of 2009. The Claymore/AlphaShares China Small Cap Index ETF (HAO) has gained about 80% over the last year, while the SPDR S&P 500 (SPY) has returned about 10% over the same period.
Room For Growth
Despite the gradual acceptance of the importance of emerging market exposure, ETF options are surprisingly limited. The ETF Screener shows more than 300 U.S. equity ETFs (excluding inverse and leveraged ETFs), but only about 30 funds offering diversified exposure to emerging markets (in addition to another 30 offering more targeted exposure to China, emerging Asian economies, and Latin America). And while investors can access almost every corner of the U.S. economy (including various styles, sizes, sectors, and strategies) through ETFs, emerging market ETFs offer primarily broad-based exposure. EEM, the most popular emerging market ETF among U.S. investors, is diversified across 10 sectors, with none accounting for more than 25% of total holdings.
|Region/ETFdb Category||Number of ETFs||Market Cap||2009 Cash Inflows/(Outflows)|
|China Equities||8||$15.9 billion||$2.0 billion|
|Asia Pacific Equities*||13||$10.9 billion||$1.7 billion|
|Latin America Equities||8||$15.0 billion||$2.9 billion|
|Emerging Markets Equities||31||$55.7 billion||$7.9 billion|
|Total Emerging Markets||60||$97.5 billion||$14.5 billion|
||307||$279.8 billion||($26.6 billion)***|
|*Excludes EWY, EWA
**Includes all non-leveraged, non-inverse equity ETFs, according to the ETFdb Screener
***Includes $29.7 billion in outflows from SPY
This imbalance is a problem EGA is looking to remedy. The company has launched four funds focusing on specific sectors of emerging market economies:
- Emerging Global Shares Composite (EEG)
- Emerging Global Shares Energy (EEO)
- Emerging Global Shares Financials (EFN)
- Emerging Global Shares Metals & Mining (EMT)
Sector plays on the U.S. economy are a critical part of most investment strategies, both long and short term. But investing in specific areas of emerging economies has historically been a cumbersome process for small and large investors alike. As U.S. investors begin to accept the necessity of expanding portfolio exposure beyond their borders, sector-specific emerging markets ETFs should see some huge cash inflows.
Disclosure: No positions at time of writing.