Posted by: Ben Steverman on October 25, 2010
For U.S. investors looking to exploit growth in emerging markets, one question is how much of their portfolios to allocate toward these fast-growing regions of the world. It’s a question I address in this story just posted on Businessweek.com.
Another key question is how to go about getting access to stocks in places like China, Brazil, India, Turkey. Most mainstream financial planners and strategists will tell you that diversification is important and buying individual stocks overseas can be a hassle, so it’s best to buy into funds. Whether exchange-traded funds (ETFs) or mutual funds, one purchase will get you exposure to hundreds of individual stocks in a dozen or more countries.
But what kind of strategy should the fund favor? The experts I spoke to are split between those who advise buying an index fund and those who insist on an actively managed fund. (An index fund’s holdings include only those stocks listed in an index like the MSCI Emerging Markets index. An actively managed fund buys and sells according to the decisions of a portfolio manager and his or her research staff.)
The debate between indexers and those who prefer active managers is long-running, but it takes on new dimensions in the emerging-markets realm:
1. The Argument For Active
Developed markets are highly efficient, adjusting quickly to new information and making it very difficult for any stockpicker to beat the market average. Emerging markets, however, are “an asset class that has lingering inefficencies,” says George Iwanicki Jr., global macro strategist within J.P. Morgan Asset Management’s Global Emerging Markets Equity Team. Smart managers can exploit those inefficiencies when they occur, he says.
Also, not all emerging markets are equal: One nation’s stock market might look expensive while another looks cheap. “Every country is a different story,” says Keith Amburgey, chief investment officer at Rutherford Asset Planning in Cresskill, N.J. A manager has the flexibility to move from country to country looking for the best opportunities. “There is a lot of value that can be added there.”
Finally, advisors warn, emerging markets indexes are often dominated by large international companies. They can miss smaller, faster-growing companies with more local focuses. Managers can go out and find these promising smaller names.
2. The Argument for Indexing
Active management is expensive. According to Morningstar, the average expense ratio for its “diversified emerging markets” mutual funds is 1.75 percent per year. Year after year, that can add up.
Popular mutual funds can be even more expensive. Morningstar gives its highest five-star rating to the Oppenheimer Developing Markets Fund, which has an expense ratio of 2.2 percent. That was the price of admission for a 114 percent total return in the last five years.
By contrast, one of the most popular ETFs in the market is the Vanguard Emerging Markets Stock ETF. It has an expense ratio of just 0.27 percent. Its return was 101 percent in the last five years, assuming dividends were reinvested.
Also, it’s impossible to know when managers will be able to outsmart the market. Emerging stock markets are notorious for sudden swings that can leave even the savviest trader exposed.
“Emerging markets equity is still a great ‘buy and hold’ story,” says Alec Young, equity market strategist at Standard & Poor’s. Making quick tactical moves is very difficult in the space, he says. Plus, he adds, with a index fund, “Vanguard will do all the work for you and they’ll do it for a quarter the price [of an] active manager.”
[An important side note: Young says that index mutual funds are more practical for individual investors than index ETFs in the emerging markets segment. Mutual funds reduce the temptation to trade, and they more efficiently and automatically re-invest your returns, like dividends, back in the fund. The ticker of Vanguard’s emerging markets mutual fund is VEIEX.]
So who is right? The majority of the financial professionals I talked with said they preferred actively managed funds, at least for emerging markets.
But, that’s not necessarily where the dollars are flowing. According to Oct. 19 data from TrimTabs Investment Research, the Vanguard Emerging Markets ETF has seen inflows of $4 billion in the last 30 days, more than any other ETF.