Buy emerging markets for the growth, not the commodities

If you’re putting clients into emerging-market ETFs to diversify away from the U.S. markets, you should think about whether your emerging-market fund actually does that.

One point to consider: The two largest sectors in the Standard & Poor’s 500 stock index are technology and financial services. Those are the two largest sectors in the MSCI Emerging Markets Index as well. In fact, 27% of the index is technology, versus about 21% for the S&P 500.

The FANG stocks (Facebook, Amazon, Netflix and Google) have led technology, contributing about 18% of the S&P 500’s gain last year. But the ANTS stocks (Alibaba, Naspers, Tencent and Samsung) have led emerging markets, contributing 43% to the index’s gains in 2017, Edward Kerschner, chief portfolio strategist for Columbia Threadneedle Investments, said in an interview at the Inside ETFs conference. The MSCI index, incidentally, has more than 800 holdings.

A common misperception about emerging-market stocks is that they are tightly correlated with natural resources and commodities. But the correlation between emerging-market stocks and the Commodity Research Bureau index of commodity prices peaked at 81% in 2011, Mr. Kerschner said. Today, technology and finance are far more important to emerging markets.

The driving force behind emerging markets, however, is the growth of the middle class in the Far East, particularly China and India. In 2000, only about 4% of the world’s middle class was in emerging markets, Mr. Kerschner said, with about 1% each in India and China. But the size of China’s middle class is expected to overtake that of the U.S. by 2020, and India will pass the U.S. a year later.

Furthermore, India and China’s demographics favor growth. India, for example, has the youngest median age of any major country, at 27. China follows at 37, while the U.S. median is 38 and Europe is 43.

“This is the U.S. postwar baby boom on steroids,” Mr. Kerschner said.

(More: How to invest in frontier markets)