Profit and Peril in Emerging Markets


By Palash R. Ghosh Stocks in 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 these regions. Year-to-date through Oct. 5, $14.8 billion in new cash entered emerging-markets equity funds, vs. an inflow of $2.8 billion for all of 2004, according to EmergingPortfolio.com.

Moreover, after a few years of consistently strong performance -- much of it driven by high commodity prices -- many emerging markets remain attractively valued relative to those of the U.S. and Western Europe.

For example, as of Sept. 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. Standard & Poor's 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.

CHINA PLAYS. 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 their 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 as 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 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.

However, 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. 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.

THREE TO WATCH. 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's 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 by 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.

WIDER APPROACHES. 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.

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's (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 such as 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.

SMALL BET. 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.

The BLDRS Asia 50 ADR Index Fund (ADRA) has limited exposure to the emerging markets, since it's dominated by Japan and Australia (78.6% of assets). However, this fund may be attractive to investors who want just a small allocation to emerging economies such as China and India.

S&P index strategist Srikant Dash says he expects more ETF products focused on the emerging markets to become available. However, they will likely feature the smaller "new frontier" segments of these markets.

EASTERN EXPOSURE. "In the last 10 to 15 years, large emerging markets such as Mexico, Taiwan, and Korea -- which make up 50% or more of most broad emerging market indexes -- have become increasingly correlated with the developed markets," Dash says. "This is because companies in these nations are becoming increasingly involved in the global supply chain. As a result, their fortunes are more closely blended with the fortunes of U.S. companies. Consequently, the broad emerging market indexes have lost a little bit of their diversification benefits."

Dash says the next wave of ETF product innovation will likely be dedicated to emerging markets such as those in Eastern Europe, including Poland and the Czech Republic. "These economies are in the position that Korea and Taiwan were 20 to 30 years ago," he says. "They're less correlated to the U.S., and would provide the investor with the diversification that makes investing in the emerging markets so appealing."

Another part of the emerging world that hasn't been tapped yet -- Africa -- may start to appear in ETF products, Dash says. "For example, there are large billion-dollar resource companies in African nations like Ghana, as well as South Africa," he says. "There are gold, diamond, platinum companies, many of which trade on the London and South African exchanges." To address liquidity issues in such markets, Dash notes, the ETF industry will probably "find a way to structure liquid baskets of stocks from these less correlated markets."

PROS ONLY. Another hot trend that the ETF industry may capitalize on is BRIC -- Brazil-Russia-India-China. "These are the largest countries in the emerging world, with fast-growth trajectories," Dash says. "We may see some ETF products that invest exclusively in these four nations as well."

Because of their increased risk, single-country ETFs are only appropriate for sophisticated investors, active traders, and institutional investors who take positions based on macroeconomic calls -- they aren't suitable for the balanced portfolio of an individual investor, Dash cautions. "Long-term investors may keep a small portion, perhaps 5% to 10% of the equity portion of their overall portfolio, in one of the broader emerging markets ETFs."

Here are some emerging markets ETFs, with their one-year returns through Sept. 30, assets, and expense ratios.

Emerging Markets ETFs

ETF

Net Assets

One-Year Return (%)

Expense Ratio (%)

Inception

Broad-Based

BLDRS Emerging Markets 50 ADR Index Fund (ADRE)

$234.0 million

53.9

0.3

Nov. 2002

iShares MSCI Emerging Markets Index Fund (EEM)

$8.19 billion

49.7

0.75

Apr. 2003

iShares S&P Latin America 40 Index Fund (ILF)

$850.0 million

82.8

0.5

Oct. 2001

Vanguard Emerging Markets VIPERS (VWO)

$351.4 million

N.A.

0.3

Mar. 2005

Single-Country

iShares FTSE/Xinhua China 25 Index Fund (FXI)

$1.27 billion

N.A.

0.74

Oct. 2004

iShares MSCI Brazil Index Fund (EWZ)

$828.3 million

83.8

0.74

July 2000

iShares MSCI Hong Kong Index Fund (EWH)

$638.4 million

23.6

0.59

Mar. 1996

iShares MSCI Malaysia Index Fund (EWM)

$414.7 million

11.3

0.59

Mar. 1996

iShares MSCI Mexico Index Fund (EWW)

$298.0 million

61.9

0.59

Mar. 1996

iShares MSCI Singapore Index (EWS)

$386.3 million

19.3

0.59

Mar. 1996

iShares MSCI South Africa Index (EZA)

$169.8 million

43.9

0.74

Feb. 2003

iShares MSCI South Korea Index Fund (EWY)

$828.4 million

55.4

0.74

May 2000

iShares MSCI Taiwan Index Fund (EWT)

$746.2 million

9.9

0.74

June 2000

PowerShares Golden Dragon Halter USX China Portfolio (PGJ)

$66.9 million

N.A.

0.6

Dec. 2004

Ghosh is a reporter for Standard & Poor's Fund Advisor


Too Cool for Crisis Management
LIMITED-TIME OFFER SUBSCRIBE NOW
 
blog comments powered by Disqus