Will Emerging Markets Lead?

The first quarter of 2009 is in the history books. Key areas of market strength have already begun to manifest themselves. Are your clients’ portfolios benefiting from the mega-investment themes that are unfolding?

One of last year’s worst performers has become this year’s best. What is it? Emerging market stocks. And this raises the question of whether emerging markets will lead an upward push for equity markets overall.

Despite the gloomy world economy, the fundamentals of emerging markets look positive. Emerging market economies are still growing at a faster rate than developed countries. Also, emerging economies aren’t hampered by the multi-billion and multi-trillion dollar government deficits currently experienced by their larger counterparts.

Consumer Dynamic

Over the past several decades consumer spending has been the engine of economic growth in developed markets like the U.S. However, the meltdown in residential real estate coupled with the subsequent global recession has greatly reduced people’s appetite for discretionary goods. Nevertheless, it appears that consumers residing in emerging market countries are poised to outspend both American and European consumers.

A survey conducted by Boston Consulting Group revealed 25 percent of Chinese and 16 percent of Indian consumers plan to increase their spending habits over the next year. A full 50 percent of respondents for both groups also reported they plan to spend the same amount as last year. Consumers abroad are becoming affluent.

There’s mounting evidence that consumer spending in emerging markets isn’t just growing, but buying patterns are changing. For example, automobile sales in China have never been so good. A record 1.11 million units were sold in March alone. Automakers have taken note, too. Porsche unveiled its new four-door Panamera model, not in Detroit or Los Angeles, but at the Shanghai auto show. Other luxury brands like Audi and Mercedes Benz have sold well in China.

Despite a gloomy world economy, consumers abroad could very well drive the economic growth of their local regions. Are your clients’ portfolios ready for these dynamic changes?

Let’s consider a few investment strategies for investing in emerging markets.

Single-Country Approach

Single-country ETFs offer convenient equity exposure to specific countries. Instead of attempting to select individual stocks from China or India, for example, you could opt for an iShares FTSE/Xinhau China 25 ETF (FXI) or the WisdomTree India Earnings ETF (EPI); such funds own a select group of stocks from a particular country. You could also opt for a total stock market approach with a fund like the SPDR S&P China ETF (GXC) that owns a broad basket of large-, mid- and small-cap stocks.

A closer look at single country ETFs will show too that certain emerging economies are often industry sector plays. For example, Taiwan (EWT) has long relied on the U.S. technology sector for its business. Russian stocks (RSX) are largely impacted by the price of oil. The iShares MSCI South Africa ETF (EZA) is closely correlated with the performance of basic materials and precious metal miners. The same phenomenon can be found in other single-country ETFs that are acutely affected by the goods and services produced in their nations.

The SPDR S&P BRIC 40 ETF (BIK) is a popular choice for investors who want to capture the performance of the four largest emerging economies on the planet: Brazil, Russia, India and China. The foursome also goes by the name of “BRIC” nations.

Investing in single-country ETFs requires attention because fund performance tends to be streaky and volatile. Among the best performing country ETFs year-to-date are EWZ, up by 18.3 percent; Chile (ECH) ahead by 21.0 percent; and EWT up by 14.6 percent (figures are through the April 20, 2009 market close).

Geographic or Regional Approach

For less aggressive investors, a lower-risk way to invest in emerging markets is through ETFs that focus on specific regions of the world. There are many ETFs that meet this criterion; let’s look at a few key ones.

The iShares S&P Latin America 40 (ILF) focuses on stocks from Argentina, Brazil, Chile and Mexico. The SPDR S&P Emerging Europe (GUR) owns stocks from the Czech Republic, Hungary, Poland, Russia and Turkey. The SPDR S&P Emerging Middle East & Africa (GAF) owns stocks from Egypt, Israel, Jordan, Morocco, Nigeria and South Africa.

Investing in emerging markets with a geographical approach limits both the economic and political risks often associated with selecting specific countries. It also allows investors to easily capture regional market trends occurring in various parts of the world.

Broadly Diversified Approach

The easiest way to invest in emerging markets without making any regional or country bets is through a broadly diverse ETF that owns the entire market. Many investors and financial professionals have gone this route to avoid the extreme market moves associated with individual countries or regions. “Emerging market stocks should play a role in any serious long-term investor’s portfolio,” states Joseph Childrey, managing partner of Childrey Investment Partners in La Jolla, Calif. He adds: “We recommend buying the asset class as opposed to identifying the next hot country or region.”

An excellent candidate for capturing pure beta market exposure is the Vanguard Emerging Markets ETF (VWO), which has risen 9.1 percent since the beginning of the year. VWO covers the equity markets of key emerging countries like Brazil, Chile, China, Israel, India, Indonesia, Korea, Malaysia, Mexico, South Africa, Taiwan, Thailand and Turkey. This particular Vanguard ETF follows a similar investment strategy as the much larger iShares Emerging Markets Index Fund (EEM), but it charges annual expenses almost three times less.

For market exposure to the emerging markets but with a strategy that weights stocks by their fundamentals, see the PowerShares FTSE RAFI Emerging Markets ETF (PXH). The fund’s annual expense ratio is 0.85 percent.

Potholes and Caveats

Despite their great potential, investing in emerging markets comes with plenty of caveats. Advisors should make certain their clients aren’t taking more risk than they can stomach. While emerging market countries have been less impacted by the ongoing credit crisis compared to the rest of the world, they are far from immune. Over the past few months, the International Monetary Fund (IMF) has extended financial aid to Belarus, Colombia, Hungary, Iceland, Latvia, Mexico, Romania, Serbia and Ukraine. Leaders of G-20 nations agreed in April to provide the IMF with $1 trillion in funding to help struggling countries.

The view of some financial professionals is that emerging markets are an inefficient marketplace that requires the skill of fund managers to select the best securities. Before buying into this theory, consider some recent statistics that show another story. Standard & Poor’s reported in its 2008 Indices versus Active Funds Scorecard the five-year performance for both that the asset and equal weighted returns of active emerging market funds trailed the S&P/IFCI Composite Index. For advisors still on the fence about whether to index or go active, building a client’s portfolio foundation first on index ETFs and layering in active funds is an option.

Overlooked Benefits

The argument in favor of investing in emerging markets is typically made, with good reason, for broader securities diversification. However, another overlooked benefit of investing overseas is for currency diversification.

In a recent radio interview on the Index Investing Show, Tom Anderson, head of the strategy and research group at State Street Global Advisors, said: “All of State Street’s SPDR family of international ETFs are denominated in foreign currency and in fact most international ETFs give you foreign currency exposure.” Thus, investing internationally can buffer your clients from weakness in the U.S. dollar.

Also, keep in mind that not all internationally focused mutual funds offer untrammeled currency exposure because some fund managers will hedge against currency fluctuations. In contrast, international and emerging market ETFs do not.

All well-built portfolios should have exposure to emerging market stocks, preferably through a low-cost index fund or index ETF. This allows you to get the market’s performance without the risk of style drift, fund manager turnover and surprise tax liabilities. o

Investing in Emerging Markets ETFs:
Single Country EM ETFs

-Global X/FTSE Colombia 20 (GXG)

-iShares FTSE/Xinhau China (FXI)

-iShares FTSE China HK Listed (FCHI)

-iShares MSCI Brazil (EWZ)

-iShares MSCI Malaysia (EWM)

-iShares MSCI Mexico (EWW)

-iShares MSCI Singapore (EWS)