Sector Investing With Emerging Markets ETFs

Published on by on November 30, 2009

As the ETF industry has blossomed in the U.S., the number of fund options has expanded rapidly, leaving investors with numerous options when allocating the domestic equity portion of their portfolios. According to the ETF Database Screener, there are currently almost 400 U.S. equity ETFs, resulting in significant overlap between many funds. Investors looking for a financials ETF have more than 20 funds to choose from, while those looking to invest in the technology sector have 28 different ETF options.

But the options begin to dwindle rapidly once investors move beyond the U.S. While ETFs focusing on nearly every corner of the world – from Africa to Canada to Japan – are readily available, achieving any degree of targeted exposure in non-U.S. markets remains a challenge. The vast majority of international equity ETFs are dominated by holdings in mega-cap companies that have operations throughout the world. The iShares MSCI Spain Index Fund (EWP), for example, has more than 40% of its holdings in Banco Santander and Telefonica, both of which generate the majoirty of revenue and earnings outside of Spain.

Another drawback of both developed and emerging markets ETFs is the lack of any degree of targeted exposure. Investors looking to invest in China’s telecom sector can’t do so without also investing in financials, utilities, and consumer industries as well. Those bullish on Brazilian tech firms don’t have a way to play that trend through ETFs without simultaneously going long the rest of the Brazilian economy.

But all of that is beginning to change.

Earlier this year, New York-based Emerging Global Advisors launched the first emerging markets ETFs to focus exclusively on individual sectors within developing economies. The funds offered by EGA include:

  • Dow Jones Emerging Markets Metals & Mining Titans Index Fund (EMT)
  • Dow Jones Emerging Markets Energy Titans Index Fund (EEO)
  • Dow Jones Emerging Markets Financials Titans Index Fund (EFN)

How To Invest In Emerging Market Sector ETFs

For most investors, the asset allocation process for equities stops with making selections on individual country and region weightings. For investors with a long-term focus, achieving diversified exposure through broad regional coverage may be optimal. But for more active investors seeking to generate excess returns, sector-specific emerging markets ETFs present some interesting options.

Historically, the drawback of investing in emerging markets has been the significant risk and volatility that comes with this asset class. But anyone who has money invested in the U.S. stock market knows that domestic investments aren’t immune to volatility by any stretch of the imagination. “Investors in the U.S. equity markets have lost half of their portfolios twice in a ten year period,” says Richard Kang, chief investment officer at Emerging Global Advisors. “To me, that sounds like the volatility one would find from an emerging market. But it happened in the U.S.”

One of the risks traditionally associated with emerging markets is that of government intervention, something that the U.S. has experienced an abundance of in recent years. Between the possibility of a windfall profits tax in the energy sector to a comprehensive regulatory overhaul in the financial industry, U.S. investors are more aware of the potential impacts of government policies than ever before.

As more and more investors begin considering investment options beyond the U.S., we present a look at how emerging market sector ETFs can be used to play certain “big picture” trends (note that we don’t explicitly recommend any of these plays – the following is meant to illustrate how investors may use emerging market sector funds in their portfolios):

Emerging Markets Metals & Mining Titans Index Fund (EMT)

If turmoil continues in the U.S. markets in coming months, a continued flight to safe haven investments such as gold and silver is a distinct possibility. For investors looking to benefit from a rise in precious metals prices while still maintaining equity exposure, an investment in companies engaged in the extraction and production of precious metals in emerging economies may be an interesting option.

Emerging Markets Energy Titans Index Fund (EEO)

Investors expecting crude oil prices to rise have historically turned to stocks like Exxon Mobil and Chevron to play this trend. But in 2009, domestic energy companies have seen stock prices struggle despite big gains in crude prices, leading some to believe that the threat of a windfall profits tax is keeping a lid on prices. For those looking to make a play on rising prices but concerned about the political risks associated with the U.S. energy sector, emerging markets energy companies may be one of the best options.

Emerging Markets Financials Titans Index Fund (EFN)

Even investors bullish on the prospects of the global financial industry may be hesitant to invest in U.S.-based banks, as the complete fallout from the comprehensive regulatory overhaul remains to be seen. Because of the continued urbanization in emerging markets, financial institutions in these economies have a steadily-increasing supply of customers, potentially leading to sustainable growth without taking on excessive risk.

On the flip-side, some investors believe the recent financial troubles in Dubai are the “canary in coal mine.” Much like troubles in Bangkok led off the Asian financial crisis in the late 1990s, there are worries that the current situation in Dubai will foretell a wave of sovereign defaults among emerging markets who have borrowed beyond their means in recent years.

Other Developments Coming

The existing sector-specific ETFs may just be the tip of the iceberg. EGA is planning several additional products focusing on emerging markets, including funds targeting the materials, consumer goods and services, health care, technology, and telecom sectors. In December 2009, New York-based Global X introduced two sector-specific China funds, including ETFs targeting the consumer and industrials sectors.