Emerging Market ETFs: Seven Factors Every Investor Should Consider

by on November 9, 2010 | Updated December 14, 2012 | ETFs Mentioned:

No matter where investors look in the developed world, the picture isn’t pretty. While the U.S. unemployment remains intolerably high, and uncertainty over the lasting effects of the latest round of QE and the coming fiscal cliff 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. [For ETF industry news, sign up for the Free ETFdb Newsletter].

While a few advanced markets managed to avoid the downturn of the last 5 years–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 drivers of the recovering 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 yielded about 35% since last year, compared to a gain of only about 3% for the Guggenheim BRIC ETF (EEB). Equally impressive are the gains in some of the smaller South American markets; the Global X/InterBolsa FTSE Colombia 20 ETF (GXG) has gained about 28% 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.

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. 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 30% 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. 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[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].

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). 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.

For investors interested in 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 [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.

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