For anyone with a long-term investment horizon, emerging-markets equities appear to offer much more lucrative growth potential than their developed counterparts at this stage in the global economic recovery.
Granted, EM equities are not without their risks; high market volatility, geopolitical uncertainty, and exposure to commodities and China are just some of the challenges facing emerging-market nations today.
Go for Growth
To put this so-called “lucrative growth” potential that everyone keeps touting when discussing emerging markets, consider the following from Research Affiliates, a respected authority in the space:
The ultimate takeaway here is that U.S. equities boast an expected annualized ten-year return of 1.1%, compared to EAFE equities at 5.3%, and most impressively EM equities, which are projected to return 7.9%. Obviously, the volatility associated with EM equities is higher; but for young investors especially, the growth potential that EM equities offer over the long-haul compared to domestic stocks should not be ignored.
Factors to Consider When Picking an EM ETF
Now, if you’ve made the commitment to allocate some capital overseas, it’s time to dive and find a “best fit” ETF for your objective. Below are some of the most important factors to consider when shopping around for an emerging-markets equity ETF.
Broad vs. Single
This is a basic distinction that many forget to address entirely. There are a number of broad-based emerging-markets equities ETFs from which to choose, just as there are many single-country funds to consider. As you might suspect, conservative and more “hands-off” investors would be wise to opt for a broad-based option so as to alleviate the burden associated with attempting to pick the right country at the right time.
On the other hand, the current economic environment is riddled with uncertainty, so more active investors may want take their chances picking a single country; for instance, one strategy might be to pick an emerging market that is not heavily leveraged to China’s economy, which is still on fragile footing.
See also Investing Abroad While Avoiding China.
Similarly, opting for a single-country ETF is a better way to implement a specific investment thesis you have in mind; for instance, you don’t want to buy an Emerging Europe ETF if you’re most bullish about Poland in light of the ECB’s continued pledge for more stimulus.
To Hedge Or Not to Hedge
The introduction of currency-hedged ETFs has opened the doors to a new style of investing that has caught fire amid a rising U.S. dollar environment. For some, the choice between opting for a currency-hedged ETF over a traditional, unhedged one boils down to their view on where the greenback is headed next; while this makes sense for some, there are many who have no idea or opinion on the subject but are still faced with making the choice when shopping for a foreign equity ETF.
In this case, investors may find it helpful to consider their investment horizon rather than their forecast of the U.S. dollar. For younger investors, it makes more sense to go for an unhedged ETF as currency returns are a huge driver of total return; the beaten down state of EM currencies at the moment presents an opportunity for those with a long-term horizon.
For conservative investors, currency hedged ETFs make a lot of sense in any economic environment; these ETFs take the currency risk out of the equation, which is very appealing to someone who might be hesitant to dip their toes in overseas equity markets to begin with.
Last but certainly not least, don’t rush the part of the research process where you actually take the time to look under the hood. When you’ve narrowed down your product list to a few options, take note of the following for each ETF when making your final comparisons:
- Total number of holdings
- % in Top 10
- Sector Allocations
As a general rule of thumb, the more concentrated a portfolio is in any one factor, be it top holdings or sector allocations, that ETF is likely more appealing for an aggressive investor; likewise, more conservative investors would be best off sticking with deep and well-balanced funds. This means looking at ETFs with a relatively high number of total holdings and no over-concentration to a few securities or any one sector in particular.
The Bottom Line
The list of factors highlighted above should help those who are researching possible ways to play international markets and need a bit more guidance to find the “best fit” ETF for their objective. Be sure you understand a fund’s strategy and the nuances associated with the product before pulling the buy trigger.
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