Seven Factors Every Investor Needs To Know About Emerging Market ETF Investing

Published on November 17, 2010

No matter where investors look in the developed world, the picture isn’t pretty. In the U.S. unemployment remains intolerably high, and uncertainty over the latest round of QE will continue to hang over stock markets. In Europe efforts to control surging deficits have been met with protests and public outrage, complicating the process of reeling in government spending through austerity and establishing a platform for sustainable economic growth. And in Japan, the central bank has taken steps to weaken the currency in order to keep the country’s important exporters competitive on the global stage. However, the country’s debt levels now approach 200% of GDP–by far one of the highest levels in the developed world–raising all sorts of red flags around a market that has been stick in economic quicksand for the better part of two decades.

While a few advanced markets have managed to avoid this malaise–namely those with significant exposure to the rapidly growing Asian market such as Australia or Singapore–it has become clear that emerging markets are the new drivers of the global economy, and that developed markets are just along for the ride. And as the “growth gap” has widened considerably, many investors believe that the “risk gap” between emerging and developed markets has contracted. The growth in these economies is the result of long-term, sustainable demographic shifts, and many emerging markets boast relatively healthy balance sheets. Moreover, in the wake of unprecedented government takeovers, legislative overhauls, and financial market interventions in the developed world, the political risk that has long been a hallmark of emerging markets has perhaps become a less significant factor [see the Definitive Guide To BRIC ETFs].

Against this backdrop, more and more investors have embraced emerging markets not as a minor allocation, but a critical component of long-term portfolios. This surge in interest has corresponded with considerable growth in emerging markets ETFs; new funds have popped up offering investors exposure to markets ranging from Peru to the Philippines, while sector and thematic funds have also appeared on the scene in recent months.

With more choices than ever before, picking through the multitude of offerings can be challenging. Below, we highlight seven key factors that investors should keep in mind when analyzing potential emerging market ETFs:

1. Going Beyond The BRIC

For some investors, emerging markets exposure begins and ends with the four BRIC economies–Brazil, Russia, India, and China–that are expected to account for a significant portion of global activity in the not-so-distant future. While each of the BRIC economies is growing rapidly, there are a number of compelling emerging markets opportunities beyond this bloc that have the potential to add both diversification and return benefits. One example is Indonesia, a rapidly developing country in southeast Asia that remains on the periphery of many portfolios. The country weathered the financial crisis better than most in the area due to its focus on domestic consumption and large market size, which puts it as the fourth most populous country in the world. The nation also has one of the lower costs of labor, so as manufacturing costs continue to rise in China and other Asian countries it seems inevitable that Indonesia will help to pick up the slack [read Why Indonesia Belongs In The BRIC].

Beyond Indonesia, opportunities abound in several much smaller markets that have delivered incredible returns to investors. Nearby Thailand has been one of the best performing economies in the world; the iShares MSCI Thailand Index Fund (THD) has skyrocketed by about 60% so far in 2010, compared to a gain of only about 15% for the Guggenheim BRIC ETF (EEB). Equally impressive are the gains in some of the smaller South American markets; Chile overcame a massive earthquake to expand at a torrid pace (ECH has gained more than 40% on the year). The single best performer comes from Colombia; the Global X/InterBolsa FTSE Colombia 20 ETF (GXG) has gained about 70% on the year.

In addition to impressive returns, the smaller emerging markets may exhibit much lower correlations to developed market equities. Over the last several years, the correlation between SPY and EEM has been close to 0.90–hardly indicative of value added through diversification. The Market Vectors Indonesia ETF (IDX), on the other hand, has a correlation of just 0.66 with SPY [also see Emerging Market Investing: Beyond The BRIC].

2. Beware Sector Biases

Many of the most popular broad-based emerging markets ETFs seek to replicate cap-weighted indexes that consist of the largest stocks by total market capitalization and afford the biggest weightings to the biggest companies. In many economies–both emerging and developed–the energy and financial sectors tend to be well represented among mega cap stocks, since oil firms and banks often become the biggest companies in any given market. On the flip side, cap-weighted indexes are often light on exposure to the consumer sector.

The iShares MSCI Emerging Markets Index Fund (EEM), the largest emerging markets ETF by total assets, serves as a good example of this phenomenon. Three sectors–energy, industrial materials, and energy–account for more than 50% of assets. The consumer services, software, business services, media, and health care sectors, on the other hand, combine to make up only about 10% of total holdings.

Among country-specific funds, the tilts towards specific sectors can be even more significant. In the case of the Market Vectors Russia ETF (RSX), close to 63% of the fund’s total assets go towards two sectors: energy and industrial materials. The iShares MSCI All Peru Capped Index Fund (EPU), which tracks the MSCI All Peru Capped Index, allocates more than 80% of holdings to the financials and industrial materials sectors.

These biases towards certain sectors don’t necessarily mean that investors should avoid these funds. But is important to be aware of the composition of the underlying holdings, and it may make sense to use additional ETFs to construct more complete exposure. The EGShares Emerging Markets Consumer ETF (ECON), for example, is an efficient way to increase the exposure to the consumer sector that receives a relatively small allocation in many emerging markets ETFs [see Case For Emerging Markets Consumer Exposure]. There are several more sector-specific emerging markets ETFs that can be valuable tools for fine-tuning exposure, including China Consumer (CHIQ), Brazil Financials (BRAF), and India Infrastructure (INXX).

3. Emerging…Or Quasi-Developed?

Many emerging market ETFs offer sizable allocations to Taiwan and South Korea, which are no longer be considered developing countries by most standards. According to The Economist, both nations rank in the top 30 for quality of life, and both are classified as developed markets by both the IMF and CIA World Factbook. The average per capita GDP (using PPP) between the two nations comes in at $30,500 a year, or roughly $1,500 less than the EU average according to the CIA World Factbook–hardly indicative of economies that belong in the same category as India and China. Furthermore, Taiwan and South Korea rank as having two of the twenty five most competitive economies in the world, surpassing nations such as New Zealand, Spain, and Italy.

Nevertheless, many emerging market funds offer huge levels of exposure to these two “quasi-developed” economies. The SPDR S&P Emerging Markets Small Cap ETF (EWX), for example, allocates 27% of its assets to Taiwan alone, one of many funds to make a significant allocation to the island economy. The same goes for South Korea, which is one of the largest individual country allocations in many emerging markets funds. The two most popular emerging markets ETFs, EEM and the Vanguard Emerging Markets ETF (VWO), both track the performance of the MSCI Emerging Markets Index. South Korea and Taiwan combine to make up about 25% of that index, meaning that the two most popular emerging markets ETFs–EEM and VWO together make up about 10% of total ETF assets–maintain significant exposure to economies that many investors and institutions consider to be developed.

Again, this exposure profile isn’t necessarily negative. South Korea and Taiwan are dynamic economies that should be included in any long-term global portfolio, regardless of whether they are best classified as emerging of developed. But for investors looking for pure play exposure, it’s important to be on the look out for developed market stowaways in emerging markets funds. Besides BRIC ETFs–which obviously focus only on emerging markets–the EGShares Emerging Market Fund (EEG) is an intriguing option; that “BRIC Plus” ETF avoids South Korea and Taiwan while also offering exposure to South Africa, Mexico, Indonesia, Malaysia, Chile, and other emerging markets [see The Ticking Time Bomb Under EEM].

4. The Small Cap Difference

Most international equity ETFs–including those focusing on both emerging and developed markets–offer exposure to the largest companies listed in a given country or group of countries. In addition to introducing some sector biases–as discussed above large caps are generally tilted towards banks and oil companies–this methodology can weaken the link between the fund’s performance and the local economy. Mega caps tend to be multi-national companies that generate cash flows from markets around world, and not only in the country where the stock is primarily listed. ETFs focusing in on small-cap securities, on the other hand, are often impacted more significantly by domestic consumption and the health of the local economies.

The iShares MSCI Brazil Index Fund (EWZ) is a good example. Over 16% of its assets are dedicated to Petrobras, one of the largest oil firms in the world whose profitability depends more on global demand for crude than on the health of Brazil’s local economy. Vale, which also makes up one of the largest allocations of EWZ, has operations across the globe and participates in mining operations through joint ventures and acquisitions in Canada, Australia, China, South Africa, and Peru, just to name a few. Small cap stocks, on the other hand, are more likely to depend on demand from local consumers, thereby making them a better “pure play” on emerging markets. [see Playing The Emerging Markets Through Small Cap ETFs].

Small caps can exhibit a significantly different risk/return profile compared to their large cap counterparts. Through October, for example, the SPDR S&P Small Cap Emerging Markets ETF (EWX) had added nearly 20% in 2010, compared to an 11% gain for the large-cap heavy EEM. It has been a similar scenario in the Chinese market, where the Guggenheim Small Cap ETF (HAO) has almost doubled the gain of large cap heavy FXI, and in Brazil, where the Market Vectors Brazil Small Cap ETF (BRF) has performed much better than EWZ this year.

Again, exposure to mega cap emerging market stocks isn’t necessarily a bad thing, and in fact it should probably be an allocation in any long-term portfolio. But investors should be aware of the market cap breakdown for their emerging market allocations [see EEM's here], and those interested in rounding out their exposure can utilize a number of ETFs that focus exclusively on small cap stocks:

  • Market Vectors Brazil Small-Cap ETF (BRF)
  • Guggenheim China Small Cap Index ETF (HAO)
  • India Small Cap ETF (SCIN)
  • IQ South Korea Small Cap ETF (SKOR)
  • SPDR S&P Emerging Markets Small Cap ETF (EWX)
  • WisdomTree Emerging Market SmallCap Fund (DGS)
  • Latin America Small-Cap Index ETF (LATM)

5. Frontier Markets: Not As Scary As You Might Think

Many investors view frontier markets as the riskiest of the world’s stock markets, exhibiting less stability, transparency, and overall levels of development than even emerging markets. As such, many are hesitant to establish exposure to these markets, assuming that the degree of risk associated with such an investment is too significant. In reality, however, not all frontier markets are in the midst of political upheaval or home to rudimentary stock markets. Most economies that fall into the frontier bucket are tabbed as such because they have lower market capitalizations and liquidity than emerging markets. While some frontier markets are currently at a lower level of development than the “mainstream” emerging markets–such as Kenya, Nigeria, or Vietnam–others are of relatively high development that are simply too small to be considered emerging markets (such as Estonia, Bulgaria, and Kuwait). Some frontier markets–including those countries of the Gulf Cooperation Council–are qualified as such because they impose restrictions on foreign investors that have only recently begun to loosen.

Most investors would likely be surprised by a look under the hood of some frontier markets ETFs; Chile and Argentina make up large allocations in the Guggenheim Frontier ETF (FRN), and countries such as Kuwait and Qatar–which both have per capita GDPs higher than the U.S.–dominate the PowerShares MENA Frontier Countries Portfolio (PMNA). A closer look at FRN sheds some more light on frontier markets. This ETF tracks the Bank of New York Mellon New Frontier DR Index, which defines “Frontier Market” countries based upon an evaluation of gross domestic product growth, per capita income growth, experienced and expected inflation rates, privatization of infrastructure, and social inequalities. This definition explains why countries such as Chile and Argentina, which have been prone to high levels of inflation in the past, are included in the list.

Frontier markets are certainly risky securities. But they have the potential to add both return enhancement and diversification benefits to portfolios, and shouldn’t be overlooked simply because investors perceive them as excessively risky stocks [see Why Frontier Markets Belong In Your Portfolio].

6. China ETFs: Multitude Of Options

China is the world’s second largest economy and the largest emerging market. The thriving Asian economy has become an increasingly important player on the global stage in recent years, as Beijing takes steps towards developing domestic markets and gradually shifting away from a dependence on exports. Many investors have begun to up their China exposure, either through a diversified emerging markets fund or a country-specific ETF.

By our count, there are 18 ETFs in the China Equities ETFdb Category and close to 160 ETFs in total that offer exposure to the country. With such a wide range of choices, picking the right fund can be a tough task. Many investors end up gravitating towards the largest China ETF option; the iShares FTSE/Xinhua China 25 Index Fund (FXI) has close to $9 billion in AUM and trades more than 21 million shares every day [see The Definitive Guide To China ETFs].

FXI offers impressive liquidity and cost-efficient exposure to the Chinese market. But it isn’t necessarily the best option for those seeking to access the entire market. FXI holds just 25 stocks, and exposure in concentrated in the oil and banking sectors, with almost no exposure to consumer or tech companies. Many of FXI’s holdings are state-owned, and the underlying holdings are almost entirely mega cap and large cap securities.

For investors interested in more complete China exposure, there are a number of ETFs that can be used as either complements to or substitutes for FXI. Guggenheim’s small cap (HAO) and all cap (YAO) China ETFs are intriguing options, as they present opportunities to invest in smaller companies that may be better positioned to benefit from a continued increase in the size and wealth of China’s middle class. Moreover, these funds may offer more diversified exposure; both HAO and YAO consist of about 150 individual holdings–six times as many stocks as FXI holds.

Global X’s suite of China sector ETFs can be interesting options for investors looking to either round out exposure or make a bet on a specific corner of the Chinese economy they believe is poised to outperform. Currently, there are ETFs focusing on several different sectors of the Chinese market, including financials (CHIX), consumer (CHIQ), energy (CHIE), industrials (CHII), materials (CHIM), and technology (CHIQ). Meanwhile, another option for investors seeking sector exposure is the EGShares China Infrastructure ETF (CHXX), which seeks to benefit from continued movement to the cities and high levels of demand for highways, railroads, and ports.

One of the newest options for exposure to China is the Market Vectors China ETF (PEK). The fund offers investors exposure to the CSI 300 Index, which consists of 300 A-Share stocks listed on the Shenzen or Shanghai Stock Exchange. PEK is the first U.S.-listed ETF to offer exposure to the A-Shares market, which consists of stocks traded in the local Chinese currency that had previously been available only to Chinese citizens. PEK does not invest directly in A-Shares, instead holding swaps that are linked to the performance of China A-Shares [ETFdb Pro Members can see the Category Report on Chinese Equities here].

7. Don’t Forget About Currency And Fixed Income ETFs

For most investors, adding emerging markets exposure to a portfolio means focusing on equities. But recent innovations in the ETF industry have resulted in a number of products that focus on fixed income and currency exposure as well, and there is a case to be made for these funds–especially in the current environment.

Emerging Market Bonds

Generally speaking, many of the world’s emerging markets have balance sheets that are in far better shape than their “advanced” counterparts. However, thanks to troublesome histories and often times unstable or untrustworthy governments, emerging market debt tends to offer a considerably higher yield than securities issued by governments in Europe or North America experience. There are currently four ETFs in the Emerging Markets Bond ETF Category which offer exposure to this slice of the market. Currently, two products–the iShares JPMorgan USD Emerging Market Bond ETF (EMB) and the PowerShares Emerging Markets Sovereign Debt Fund (PCY)–offer exposure to bonds denominated in U.S. dollars, while another two–the WisdomTree Emerging Markets Local Debt ETF (ELD) and the Market Vectors Emerging Market Local Currency Bond Fund (EMLC)–target bonds denominated in local currencies. While there are pros and cons to each type of exposure–generally speaking, dollar-denominated bonds take out the currency risk for the American investor, but may offer lower interest rates than local currency debt–these funds may be effective tools for boosting the current return of a portfolio [read Why Emerging Market Bond ETFs Are Safer Than Developed Markets].

Currency ETFs

Much like in the emerging market bond category, a variety of choices exist for investors seeking emerging market currency exposure. One of the most popular choices for investors seeking diversified access is the WisdomTree Dreyfus Emerging Currency Fund (CEW). The fund has over $250 million in assets under management and offers investors exposure to currencies in three key emerging regions of the world: Latin America, Asia, and Europe, the Middle East and Africa. A basket of 8 to 12 currencies is selected on an annual basis. The selected currencies are equal weighted in terms of U.S. dollar value following the annual review and rebalanced each subsequent quarter thereafter. Given its short-term focus and lower risk nature, investors might be surprised to learn that the fund has gained over 8% in the past two quarters [see Inside The Not-So-Simple Currency ETFs].

When considering exposure to emerging markets currencies, it’s important to keep in mind exactly what investors are getting. While the idea of a currency ETF may conjure up notions of highly leveraged bets on exchange rates, the WisdomTree currency products actually seek to deliver total returns reflective of both movements in exchange rates and money market returns available to foreign investors. So it may be more appropriate to think of these funds as short-term fixed income securities that layer on exposure to foreign currencies.

In addition to the broad-based CEW, there are a number of products that target individual emerging market currencies:

  • WisdomTree Dreyfus Chinese Yuan (CYB)
  • WisdomTree Dreyfus Brazilian Real Trust (BZF)
  • Market Vectors Chinese Renminbi/USD ETN (CNY)
  • CurrencyShares Mexican Peso Trust (FXM)
  • WisdomTree Dreyfus Indian Rupee (ICN)
  • WisdomTree Dreyfus South African Rand (SZR)
  • CurrencyShares Russian Ruble Trust (XRU)
  • Market Vectors Indian Rupee/USD ETN (INR)

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Disclosure: Eric is long EWM, EWZ, EZA, PCY, and VWO. Photo is courtesy of Agnieszka Bojczuk.