Over the years, 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.
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. While each of the BRIC economies are viable investments, there are a number of compelling emerging markets opportunities beyond this bloc that have the potential to add both diversification and return benefits.
Besides broad-based emerging market ETFs, which often overweigh the BRIC countries, there are several regional and country specific options investors can utilize in order to tap into markets beyond BRIC. Be sure to check out the ETFdb Types Page, where you can narrow down the emerging market options.
2. Beware of 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.
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. Based on its classification system that considers (1) per capita income, (2) export diversification, and (3) degree of integration into the global financial system, the International Monetary Fund (IMF) announced more than ten years ago that Taiwan, South Korea, and Israel were classified as developed markets.
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.
For a more in-depth look at this issue, please read Are Taiwan, South Korea and Israel Developed or Emerging Markets?
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.
Small cap stocks are more likely to depend on demand from local consumers, thereby making them a better “pure play” on emerging markets. Small caps, however, can exhibit a significantly different risk/return profile compared to their large cap counterparts.
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, and those interested in rounding out their exposure can utilize a number of ETFs that focus exclusively on small cap stocks:
- Emerging Market SmallCap Fund (DGS )
- SPDR S&P Emerging Markets Small Cap ETF (EWX )
- India Small-Cap Index ETF (SCIF )
- China Small Cap ETF (HAO )
- iShares MSCI Emerging Markets Small-Cap ETF (EEMS )
- Market Vectors Russia Small-Cap ETF (RSXJ )
- MSCI India Small Cap Index Fund (SMIN )
- db X-trackers Harvest CSI 500 China-A Shares Small Cap Fund (ASHS )
- iShares MSCI China Small-Cap ETF (ECNS )
- Emerging Markets Small Cap AlphaDEX Fund (FEMS )
- India Small Cap ETF (SCIN )
- Market Vectors Indonesia Small-Cap ETF (IDXJ )
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.
The three ETFs that exclusively focus on frontier markets are:
- Guggenheim Frontier Markets ETF (FRN )
- ISPX record for Global X Next Emerging & Frontier ETF (EMFM )
- iShares MSCI Frontier 100 Index Fund (FM )
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. To learn even more about frontier market ETFs, be sure to read Frontier Market ETF Investing: An ETF Database Guide.
6. China ETFs: Multitude Of Options
China is the world’s second largest economy and the largest emerging market. As such, many investors have begun to up their China exposure, either through a diversified emerging markets fund or a country-specific ETF.
The China Equities ETFs ETF Database Category offers a wide variety of options. In addition, there are a multitude of funds that offer significant exposure to Chinese equities. These ETFs provide both broad-based and targeted exposure to Chinese equities, including sector-specific and market-capitalization options. In addition, for those investors looking for a big way to bet on China, there are multiple inverse and leveraged ETFs.
Be sure to also read China ETF Investing: An ETF Database Guide.
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 Markets Bonds ETFs offer exposure to both broad and country-specific debt issuers. Some of these funds also provide exposure to local-currency denominated fixed income securities, while others target only U.S. dollar-denominated bonds. 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
Much like in the emerging market bond category, a variety of choices exist for investors seeking emerging market currency exposure. There is currently only one fund that offers exposure to a basket of emerging market currencies: the WisdomTree Emerging Currency Fund (CEW ).
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:
The Bottom Line
As highlighted above, there are multiple options available for investors looking to tap into emerging markets. Whether its broad-based exposure, or hyper-targeted strategies, these ETFs provide investors with tremendous growth opportunities and diversification benefits.
Disclosure: No position at time of writing.
