Emerging Markets ETFs Come Into Their Own

Stocks of the emerging markets continue to soar as investors, turned off by tepid returns from the U.S. and other developed economies, are increasingly attracted to the emerging world. Year-to-date through October 5, $14.8 billion in new cash has entered emerging markets equity funds, versus an inflow of $2.8 billion for all of 2004.*

Moreover, after a few years of consistently strong performance — much of it driven by high commodity prices — many emerging markets still remain attractively valued relative to the U.S. and Western Europe. For example, as of September 30, based on 12-month trailing P/E, emerging market stalwart Brazil still trades at a modest 10.7, according to data from S&P/Citigroup Global Equity Indices. Similarly, Malaysia trades at only 12.3, while Mexico is priced at just 8.3. As a whole, the emerging markets trade at about 13.3, while U.S. equities trade at 21.0.

For investors seeking to cash in on these climbing markets, exchange-traded funds (ETFs) provide an appealing alternative to mutual funds because of their transparency and much lower expenses. FundAdvisor identified 14 ETFs that invest exclusively in emerging markets equities. Most, however, invest in a single country, and can court significantly more market and political risk.

Surveying the Landscape

Like the markets they seek to mimic, emerging markets ETFs come in all shapes and sizes. Some so-called “emerging markets,” like South Korea, could arguably be considered “developed,” given diversified economies, relatively stable political structures, and sophisticated market establishments. Nations classified as truly “emerging,” like China, are at a relatively early stage of their economic development, operating under either unstable political leadership, or governments that have yet resisted free, open-market economic philosophies. Such countries are typically dominated by one or two industries, and their stock markets are often illiquid, and subject to wild swings.

Due to its insatiable appetite for foreign commodities and enormous potential, China in fact has become the world’s economic growth engine. However, it remains difficult, if not impossible, for non-Chinese investors to participate directly in these markets. One convenient alternative is iShares FTSE/Xinhua China 25 Index Fund (FXI), which invests in the largest, most liquid China-based companies trading on the well-established Hong Kong Stock Exchange. But there are a few things to consider before investing here. Despite China’s promise, a very concentrated portfolio coupled with the country’s growing pains can likely spell high volatility for this ETF going forward. Investors must deal with a host of issues associated with investing in China, still a communist country. These range from corporate governance to the evenness of China’s expansion, which is likely to experience periods of booms and busts.

Outside of China, an emerging market that western investors tend to overlook is Malaysia, a relatively stable and prosperous Southeast Asian powerhouse with an educated workforce and strong export partners that include China. With 79 holdings, the iShares MSCI Malaysia Index Fund (EWM) provides good sector diversification. Reflecting the nation’s maturing industrial landscape, the fund invests in a number of sectors. Banks account for the largest slice (22.6%), followed by food, beverage & tobacco (11.2%), consumer services (11.2%), utilities (10.7%), transportation (9.6%) and telecommunication services (9.1%). South Africa is another emerging market that offers some diversification. Although the country is famous for its mining industry, that is only part of the story. Materials, at 19.5%, indeed represents the top sector of the iShares MSCI South Africa Index Fund (EZA). But this ETF portfolio also has exposure to banks (14.7%), energy (13.7%), insurance (10.8%), and telecommunication services (9.8%).

In recent years, Brazil has been among the world’s most explosive markets, but investors must remember that this economy is dominated buy just two sectors, materials and energy. These two industries alone currently account for 54.3% of the iShares MSCI Brazil Index Fund (EWZ). Moreover, Brazil’s political system seems to wallow in perpetual chaos, adding still more risk to the equation. Still, with oil prices high and commodity sales to China robust, Brazil may continue to deliver strong returns. Indeed, foreign investors have given Brazil their vote of confidence by pouring cash into its markets.

For investors who are enamored with Latin America, but don’t want to put all their eggs in one basket, the iShares S&P Latin America 40 Index Fund (ILF) is a better option. This ETF invests in four countries: Brazil, Mexico, Chile and Argentina, with the first two nations representing the lion’s share of assets (86.9%). This fund also offers somewhat better sector diversification than the single-country Brazil and Mexico ETFs. Top sectors comprise materials (29.0%), telecommunication services (20.2%), energy (14.3%) financials (14.2%), and consumer staples (11.7%). Still, it poses a lot of region-specific risk since Latin America represents just one emerging market.

To be sure, ETFs that invest broadly in emerging markets even better minimize country, industry-specific, market, and currency risk. For example, iShares MSCI Emerging Markets Index Fund (EEM) top country allocations include Korea (16.8%), South Africa (12.5%), Brazil (11.0%), Taiwan (10.6%), and China (7.8%). This ETF also provides exposure to under-represented emerging economies like India (5.3%), and Thailand (2.9%). Industries are virtually evenly spread in this portfolio. The top five sectors comprise energy (15.0%), banks (14.9%), telecommunication services (14.2%), materials (13.8%) and semiconductors (13.2%). With 265 holdings currently, this emerging markets ETF has very broad diversification. Vanguard Emerging Markets VIPERS (VWO), which tracks the MSCI Select Emerging Markets Free Index, counts Korea (19.7%), Taiwan (16%), Brazil (12.2%), South Africa (11.9%), and Mexico (6.9%) as it largest country holdings.

Another vehicle for broader exposure to the emerging markets comes from the BLDRS Emerging Markets 50 ADR Index Fund (ADRE), which is, strictly speaking, not an ETF, but a unit investment trust. This portfolio invests in American Depositary Shares (ADRs) of foreign companies that trade on U.S. exchanges, giving investors the benefits and comfort of buying stocks directly on familiar boards. While Brazil, China, Taiwan and Korea represent the top country allocations, BLDRS Emerging Markets 50 ADR Index also has exposure to India.