As developed economies stagnate under the burden of rising unemployment and deteriorating fiscal situations, investor interest in emerging markets continues to climb. The gap in growth potential between the developed and emerging worlds has never been wider, while the gap in risk has perhaps never been more narrow. Through the first nine months of 2010, cash inflows into the Emerging Markets ETFdb Category topped $20 billion, or nearly twice the amount that flowed into domestic equity ETFs. The majority of cash inflows are into broad-based funds linked to cap-weighted indexes dominated by mega cap firms, such as the MSCI Emerging Markets Index (both EEM and VWO–aggregate assets of more than $81 billion–seek to replicate this benchmark).
But many investors are now beginning to realize that the exposure offered by large cap-heavy ETFs doesn’t necessarily line up with the thesis behind an investment in emerging markets and the factors responsible for impressive growth projections. Many of the most popular emerging market ETFs exhibit biases common among cap-weighted international equity funds: heavy tilts towards energy companies and banks, along with a relatively minor allocation to the technology and consumer sectors. And in the world’s developing economies, it is a surge in consumer spending that is expected to account for a major portion of future growth.
While Americans have turned their focus to savings and repairing damaged balance sheets, consumers in emerging markets have begun a massive spending spree fueled by rising income levels, increased financial security, and optimism over their economic futures. In 2009, when aggregate credit card balances of U.S. consumers slid by nearly 9%, balances in China and Brazil increased by close to 17% and 30%, respectively. Those increases weren’t the result of careless spending, but rather more widespread availability of credit and an increase in the number of people willing and able to spend. “More people going into debt might not sound like a desirable development, but in some ways this could be,” writes Mark Whitehouse. “One of the global economy’s biggest problems has been its dependence on an overstretched U.S. consumer. If folks in places such as China and Brazil are now stepping up and taking on some of the burden, that could provide some much-needed rebalancing.”
This surge hasn’t come and gone, but rather could continue to play out over the next several decades. And for investors looking to climb aboard, there are several ETF products out there that present compelling investment cases [also see Sector Investing With Emerging Market ETFs].
Demography Is Destiny
In addition to flat-lining economies, many advanced Western nations are home to slow-growing or even shrinking populations. That is a stark contrast to emerging markets, which have young, rapidly-growing populations poised to hit peak earnings power in the next few decades. Of the roughly 100 people that are born every 43 seconds, only two are born in developed economies; emerging and frontier economies account for the vast majority of global population growth.
Also swelling is the size of the middle class in emerging markets, thanks largely to ongoing urbanization. As citizens of China, India, and other emerging markets move towards large cities and take up non-agricultural employment for the first time, the number of consumers with the means to spend disposable income is skyrocketing. “You have to ask yourself: what is it that is driving the stock market?” says Richard Kang, CIO and Director of Research at Emerging Global Shares. “And we believe it is infrastructure and consumption. Once you have the infrastructure in place, then you can start to produce goods and then you start making real money which allows you to consume.” By some estimates, emerging markets will be home to close to 93% of the global middle class by 2030. While the two billion members of the emerging markets middle class currently spend about $6.9 trillion annually, that figure could rise to $20 trillion by the end of the decade.
This would obviously be a very positive development for consumer companies in emerging markets, which would see the universe of potential customers expand significantly. Despite this tremendous potential, however, there remains a significant gap between the values of the consumer companies in the developed and emerging markets. According to research from Merrill Lynch, the market capitalization of consumer stocks in the U.S., Western Europe, and Japan recently totaled $4 trillion. Meanwhile, in China and India–two economies expected to account for a significant portion of global growth–the sectors add up to a market cap of just under $100 billion [see Emerging Market ETFs: Where's The Consumer Exposure?].
In recent years U.S. investors have begun to shed the “home country bias” that has historically tilted the asset allocation process towards U.S. and western Europe equities and away from emerging markets perceived to be excessively risky. The aggregate exposure to emerging markets has increased dramatically, as evidenced by the massive inflows into broad-based funds such as EEM and VWO. But many investors are still light on exposure to the consumer sector–a corner of the economy that is expected to be a major driver of future growth. “Many investors believe that consumers in India or Mexico don’t have big wallets,” says Kang. “While this may be true in a nominal sense, you have to remember there are a lot of them, and they are younger. When you are younger you spend more; it’s just the baby boomer phenomenon playing out elsewhere.”
Local Or Multinational?
Some would argue that domestic ETFs such as SPY offer exposure to the emerging market consumer through Western “super-brands” such as Coke and McDonald’s that maintain a worldwide reach and are embracing emerging markets as a critical source of future growth. Since these companies tend to generate significant portions of sales in emerging markets, they present an opportunity to capitalize on increased consumption in India and China through investments in companies headquartered in the U.S. and listed in New York.
However, some recent research suggests that multi-nationals may miss out on some of the emerging markets boom. According to a report by McKinsey on 17 different consumer product categories, the market leader in 1925 remained in either the top spot or second for total market share for the rest of the century. This is important because it shows how stubborn consumers are to change their purchasing habits and that local companies in emerging markets–which currently dominate their respective countries–look likely to stay on top for the foreseeable future. [see the full list of Consumer Discretionary ETFs here].
Despite the increased Western presence in emerging markets, many firms have failed to post significant gains in market share in a variety of product categories. In the Chinese beer market–the largest in the world–multinational firms have not made any meaningful gains in market share since 2003, and make up roughly 10% of the market. Meanwhile, a similar situation is ‘brewing’ in Brazil, where local beer giant Ambev accounts for nearly 70% of market share and has prevented Western firms from establishing a foothold.
The difficulty of international firms gaining traction in emerging markets is due to a number of factors. Local firms are able to more accurately gauge local taste preferences, and there are policy-driven reasons behind this dominance as well. “China is trying to favor their own companies,” says Kang. “That’s why you want to go for companies like Dongfeng motors in China or Bajai Auto in India; not only are they pure plays, but they are on the home team.”
Continued innovation in the ETF space has resulted in a number of options for investors looking to gain exposure to the consumer sector of emerging markets, potentially acting as a complement to funds such as EEM and VWO. The recently-launched Dow Jones Emerging Markets Consumer Titans Index Fund (ECON) is one choice; ECON tracks the Dow Jones Emerging Market Consumer Index, a free-float market cap weighted benchmark of 30 emerging market companies in the consumer goods and consumer services sectors. Currently, the fund is heavily weighted towards four key countries: Mexico (19.9%), India (16.6%), Brazil (16.1%), and South Africa (14%). Additionally, Malaysia, China, and Indonesia all make up significant weights in the fund as well.
The index includes the ten largest consumer goods companies and the ten largest consumer services companies, rounded out by the next ten largest companies from either group not already included in the index. Unlike most emerging markets ETFs, multiple non-BRIC economies are among the largest individual allocations in the index, and no single market makes up more than 20% of the underlying index.
From a sector perspective, ECON makes material allocations to automakers and parts suppliers, food producers, beverage companies, and travel and leisure firms, among many other corners of the consumer sector. The fund is a recent addition to the ETF space, but has come flying out of the gates by gaining close to 8% since the launch in September. Through the first three quarters of the year, the index underlying ECON had added more than 26%.
Somewhat surprisingly, ECON is the only ETF available to U.S. investors that exclusively targets the consumer sector of various emerging markets. But there are a few other options for investors looking to tap into the consumer sector of the developing world. Global X also offers two funds providing more targeted exposure to the consumer sectors in two of the world’s largest emerging markets; the China Consumer ETF (CHIQ) and Brazil Consumer ETF (BRAQ) are among a growing number of funds that offer sector-specific, single-country exposure beyond the U.S. State Street also offers a fund focusing on small cap stocks in the emerging world; unlike broad-based large cap funds, the SPDR S&P Emerging Markets Small Cap ETF (EWX) offers material allocations to consumer goods, consumer services, and technology while affording only very small weightings to energy.
Disclosure: No positions at time of writing; photo is courtesy of Chris Goldberg.