Should You Consider Emerging Markets Exchange-traded Funds?

Emerging Markets Overview and Characteristics

Emerging markets include Brazil, Russia, India and China as well as Taiwan, Argentina, Turkey, Pakistan and others.

Faster Growth

Emerging market economies are generally growing at a faster rate than the developed world and this is set to continue for many years. The economies are increasingly driving their own growth as domestic consumer spending and trade between emerging market countries are becoming much more important. As a result, emerging markets rely less on global economic growth than in the past.

Improving Balance Sheets

Emerging markets have better overall economic fundamentals than the developed world, in terms of current account balances and government debt. There has also been structural improvements across many of these countries in recent years, with foreign debt levels down sharply and increased foreign exchange reserves.

Long Term Outlook

Although there is near term uncertainty due to the potential for a global recession and a constant battle against inflation, the medium to long-term investment case for emerging markets remains compelling.

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What is Emerging Market ETF?

An exchange-traded fund that focuses on the stocks of emerging market economies, such as Latin America, Asia and Eastern Europe. The underling indexes tracked by emerging market ETFs vary from one fund manager to another, but all should be passively managed and contain equities from multiple countries, unless otherwise stated.

Within the broad class of emerging market ETFs, there are fund members that focus on certain market-capitalization ranges, high-dividend stocks, or funds with high allocations towards specific sectors.

How does an Emerging Markets ETF work?

A sponsor, mainly a huge bank or a big financial institution, creates a plan of an investment scheme to test its attraction value. If the reception to such a scheme is good, the bank purchases the necessary stocks. However, that may differ from industries to regions, and sectors. Once the portfolio is completely bought, it is deposited with a trustee. The trustee issues ETF certificates which are later marketed. The value of the stock is priced slightly higher than the real value for profits.

Advantages of EFTs
 
There are many advantages to these ETFs besides hedging like:
  • Foreign markets and the local markets do not behave similarly all the time. Therefore, when one economy does not do well, the losses can be neutralized.
  • When the emerging economies http://konac.kontera.com/javascript/lib/imgs/grey_loader.gifperform well, the ETFs’ value increases. Brazil and South Korea are two good examples.
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Disadvantages of EFTs

The disadvantages of these ETFs are:
  • In difficult times like recession, the decreased money flow can limit the growth of emerging market, and thus impact the value of the ETF.
  • If the ETF has markets that are dependent on each other or on a common market, then a slight disturbance in one market can create turbulence elsewhere.
Types of emerging market ETFs

The popularity of Emerging Markets investing has lead to the introduction of several types of ETFs.

Total Emerging Markets

The most popular ETF is iShares MSCI Emerging Markets Index Fund (EEM) which tracks an index that captures 85% of the market capitalization of the emerging markets.  Vanguard has a similar offering with a lower expense ratio of only 0.25% - the $6 billion Vanguard Emerging Markets ETF (VWO).
Other ETFs that capture most or all of the emerging markets include State Street's SPDR S&P Emerging Markets ETF (GMM) and PowerShares FTSE RAFI Emerging Markets Portfolio (PXH).

Market Cap

The single large cap ETF is PowerShares BLDRS Emerging Markets 50 ADR Index Fund (ADRE).  Two small cap offerings include the WisdomTree Emerging Markets SmallCap Dividend Fund (DGS) and the recently introduced SPDR S&P Emerging Markets Small Cap ETF (EWX).

Specialty

For dividend investors, WisdomTree also offers the Emerging Markets High-Yielding Equity Fund (DEM). Technical investors can choose the DWA Emerging Markets Technical Leaders Portfolio (PIE)

Short

Two ETFs are available for taking short positions on the Emerging Markets.  ProShares' Short MSCI Emerging Markets (EUM) and UltraShort MSCI Emerging Markets (EEV) enable investors to hedge their portfolios without having to borrow shares.

Regional Funds

State Street has introduced a series of regional Emerging Market ETFs that cover the Middle East and Africa (GAF), Latin America (GML), Asia Pacific (GMF) and Europe (GUR).
In addition single country ETFs are available for some of the emerging market economies.

Bond Funds

Fixed income ETFs are also an option for Emerging Markets investors.  The PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) and the JPMorgan USD Emerging Markets Bond Fund (EMB) are the two choices.

Investing in Emerging Markets – How much is Right?

Emerging market companies make up 20% of total global market capitalization and emerging economies make up nearly 27% of global GDP. Harvard and Yale Endowments have found emerging markets investments compelling enough to allocate 30% of their equity investments.

While such large allocations may be suitable for some institutions, most individual investors would do well to consider volatility and their capacity to take on roller coaster rides. Over the past two and a half years, emerging market stocks have proven to be nearly 70% more volatile than U. S. stocks and 44% more volatile than developed market stocks. Limiting emerging market exposure to less than 15% of one’s assets may not be a bad idea for most individual investors.


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