Going Beyond EEM: Rounding Out Emerging Markets Exposure With ETFs

by on January 6, 2011 | ETFs Mentioned:

In recent years, emerging markets have been established as the clear leaders of global GDP growth, while the economies of the U.S. and western Europe have stalled. Developed markets are facing stubbornly high unemployment and limited flexibility thanks to mounting debt burdens, while emerging markets continue to race ahead. In a recent economics paper, Goldman Sachs re-examined the prospects of emerging markets, and struck an extremely bullish tone for the future. Goldman’s report makes numerous bold (but well supported) claims, including the expectation of China to surpass the US in equity market capitalization by 2030 and become the single largest equity market in the world. The report also notes that emerging markets currently account for 37% of global GDP, but that that percentage will increase to 49% by 2020 and 59% by 2030 [see ETFs For The "Next-11" Economies].

The rise in global economic importance of emerging markets has coincided with a rise in the usage of ETFs, so it shouldn’t be surprising that many investors have embraced the exchange-traded structure as a means of establishing their emerging markets exposure. The most popular options are EEM and VWO; these two funds are linked to the MSCI Emerging Markets Index, a benchmark that includes the largest publicly-traded companies in the developing world. Both EEM and VWO are great products; they offer incredibly liquid and cost-efficient exposure to a diversified basket of stocks listed in more than a dozen of the world’s fastest-growing economies [check out the Emerging Markets ETF Center]. But for complete emerging markets exposure, they are only a starting point, and investors could potentially enhance their international equity portfolios by considering some complementary holdings:

Small Cap Exposure

Most international equity ETFs, including those focused on both emerging and developed markets, only offer exposure to the largest companies listed in a given country or group of countries. In addition to the above mentioned market-cap biases, sector biases are prominent as well, since large caps are generally tilted towards financial and energy companies. Also, large and 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. As such, their profitability is impacted not only by local consumption, but by conditions in other markets (including developed economies). So the focus on large caps can potentially weaken the link between the fund’s performance and the local economy [see ETFs For The Forgotten Asset Classes].

Gaining diversified small-cap exposure within emerging economies was a tough task for the average investors a few years ago; now there are numerous ETF options available to tap into this asset class. The SPDR Emerging Markets Small Cap ETF (EWX) issued by State Street can be a powerful complement to EEM for those interested in adding diversification within their emerging market exposure. EWX tracks the S&P Emerging Markets Under USD2 Billion Index, a float adjusted market cap-weighted index that represents the small capitalization segment of emerging countries included in the S&P Global BMI Index. EWX offers exposure to the smaller economies of emerging markets that could be positioned to benefit from increased local consumption in coming years. Moreover, EWX maintains a sector allocation very different from EEM and VWO, bringing some balance to a portfolio from that perspective as well. The small cap fund has 19% of its assets allocated to the information technologies sector, 17% in industrials, 16% in financials, and 15% in consumer goods.

For investors seeking more targeted small-cap exposure, there are also a handful of country specific small cap ETFs as well:

  • Market Vectors Brazil Small-Cap (BRF)
  • India Small-Cap (SCIN)
  • Latin America Small-Caps (LATM)
  • Guggenheim China Small-Cap (HAO)

[To find more country specific ETFs try using our free Country Exposure Tool.]

Consumer Exposure

While American consumers have turned their focus to savings and repairing damaged balance sheets, consumers in emerging markets are picking up the slack. Across the globe, consumers in developing countries are increasing their spending habits due to rising income levels, increased financial security, and overall optimism about the future. In addition to stagnant economic growth, many Western nations are home to slow-growing or even shrinking populations. Emerging markets, on the other hand, have young, rapidly-growing populations posed to hit peak earnings power in the next few decades. Improving infrastructure and increased telecommunications spending in developing countries is further contributing to urbanization, as rural areas of emerging markets expand and the emerging market middle class continues to swell. Millions of emerging markets residents are moving to cities and taking up non-agricultural employment for the first time. And with that move comes the introduction of discretionary income, and widespread availability of cars, electronics, and other consumer products.

With this favorable demographic shift expected to play out over the next few decades, the emerging markets consumer sector seems poised for explosive growth; the emerging markets middle class currently spend about $6.9 trillion annually, and that figure could rise to $20 trillion by the end of the decade [see Case For Emerging Market Consumers]. Yet many investors are light on consumer exposure, as cap-weighted benchmarks tilt towards energy and financials and go light on the consumer sectors.

The Dow Jones Emerging Markets Consumer Titans Index Fund (ECON) is a good option for those interested in adding broad based emerging-market consumer exposure to their portfolio. ECON tracks the Dow Jones Emerging Market Consumer Index, which is a free-float market cap weighted index of 30 leading emerging market companies in the consumer goods and consumer services sectors. Currently, the fund allocates about 20% of its assets with exposure to Mexico, 17% in India, 16% in Brazil, and around 14% in South Africa [see ECON Fact Sheet]. ECON is also unique in that unlike most emerging markets ETFs, multiple non-BRIC economies are among the largest individual allocations in the index, with no single market making up more than 20% of the underlying index.

Investors seeking more targeted consumer sector exposure also have a couple of ETF options:

  • Brazil Consumer ETF (BRAQ)
  • China Consumer ETF (CHIQ)

Emerging Markets Bonds

Most investors examining an equity portfolio consisting entirely of U.S. stocks would hold off on a stamp of approval for diversification. Yet when it comes to fixed income exposure, many portfolios begin and end with investment grade debt from U.S. issuers. Foreign bonds often offer investors more robust yields than domestic fixed income securities, thanks to higher discount rates and more meaningful concerns about inflation [see Why Emerging Market Bond ETFs Are Safer Than Developed Markets]. Moreover, emerging market bonds denominated in the local currency can offer dollar diversification–and the potential for increased returns when currency exchange rates are unfavorable for the dollar.

One of the newest additions to the Emerging Markets Bond ETFdb Category, is the Wisdom Tree Emerging Market Local Debt Fund (ELD). The fund is an actively managed ETF that invests in debt of emerging market issuers—many of which boast relatively strong balance sheets and creditworthiness. ELD attempts to achieve its objective through investment in local debt denominated in the currencies of emerging market countries. At around 11% allocation each, the top four country holdings of ELD are Mexico, Malaysia, Brazil, and Indonesia.

Investors interested in additional emerging markets bond exposure should consider these ETFs:

  • Market Vectors Emerging Markets Local Currency Bond (EMLC)
  • PowerShares Emerging Markets Sovereign Debt Portfolio (PCY)
  • iShares JP Morgan Emerging Bond Fund (EMB)

Emerging Markets Currency

The currency ETF space in particular has seen a great deal of growth, expanding from products that offer simple exposure to exchange rates between two countries to more complex and diversified instruments. Emerging market currency funds are an intriguing asset class–a way to invest in emerging markets through assets that have historically shown significantly lower volatility than equities. According to WisdomTree (PDF), over the last ten years an equally weighted basket of emerging currencies had an annualized volatility of 7.1%, while an equally weighted basket of emerging market stocks from the same countries had a volatility of 25.6% [see Emerging Market ETFs: Seven Factors Every Investor Must Consider].

The WisdomTree Dreyfus Emerging Currency Fund (CEW) is a popular product amongst those seeking emerging market currency exposure. CEW seeks to provide returns that reflect both money market rates in certain emerging market economies and changes in the value of these currencies relative to the U.S. dollar. The fund is actively-managed and holds a basket of 8 to 12 currencies that meet certain liquidity requirements [see CEW Fact Sheet].

CEW is a far cry from ultra-risky leveraged forex investing; it is perhaps more appropriate to think of this ETF as an ultra-short term fixed income fund, with dollar diversification layered on top.

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Disclosure: No positions at time of writing.