Scrutinize emerging-markets funds
The growing middle class in many developing countries has made them an attractive place to invest. But most…
The growing middle class in many developing countries has made them an attractive place to invest. But most broad emerging-markets funds aren’t giving investors the exposure to those economies that they probably expected.
Consider, for example, the MSCI Emerging Markets Index, the most widely tracked emerging-markets benchmark. More than 26% of that index is represented by South Korea and Taiwan, two countries that were upgraded to developed status in 1997 by the International Monetary Fund.
Even beyond significant exposure to developed markets, most broad emerging-markets index mutual funds and exchange-traded funds have little invested in the true drivers of emerging-markets economies.
Because of the market-capitalization-weighted nature of most indexes, the largest weighting is given to sectors that don’t best represent the real growth of an economy.
The MSCI benchmark, for example, is more than 50% exposed to the energy, financials and materials sectors, which tend to be more linked to the global economy than to local markets.
A February report by Emerging Global Advisors LLC said that those three sectors, which are export-dependent, play a major role in help- ing countries move from frontier to emerging status.
However, the report explained, in order to tap into the growth of a country moving from emerging toward developed status requires exposure to domestic-demand sectors such as consumer discretionary and consumer staples.
Those two sectors represent just 16.3% of the broad emerging- markets index. And when you take out the South Korean and Taiwanese names, that percentage drops to 12%.
“It’s one of those little secrets that people don’t talk about,” said David Semple, manager of the Van Eck Emerging Markets Fund (GBFAX).
Considering that the average exposure to developed markets by emerging-markets mutual funds tracked by Morningstar Inc. is almost 27%, the index weightings might not seem all that egregious.
TYPE OF EXPOSURE
But as Mr. Semple said, investors should also be mindful of the kind of exposure that they are getting even within the emerging markets.
“Energy is a real standout, and in most emerging countries, energy can be represented by a state-owned monopoly,” he said. “Investors are still getting emerging-markets exposure with a fund heavily weighted in energy, but it’s probably not the kind of emerging-markets exposure they want.”
Many country-specific indexes are flush with examples of extreme over- and underweights. The FTSE China 25 Index, for instance, has a 53% weighting in financials and no exposure to consumer sector stocks.
Although it might be easy for an adviser to check the box of emerging-markets exposure by allocating to a broad emerging-markets index fund, this area requires fine-tuning.
The emerging markets now represent 14% of global market capitalization, but according to Emerging Global Advisors, most investors have only about 4% allocated to them. Of that 4%, about 25% is made up of developed-markets stocks.
“As investors increasingly discriminate within emerging markets, they are realizing their broad-base emerging-markets exposure is not what they thought it was,” said Marten Hoekstra, chief executive of Emerging Global Advisors.
CONSUMER FUNDS
That premise is the foundation for companies such as Emerging Global Advisors, which over the past three years has launched 19 ETFs designed for targeted exposure.
EGShares Emerging Markets Consumer (ECON), for example, is an ETF that invests in emerging-markets consumer companies.
Other targeted consumer funds include Global X Brazil Consumer ETF (BRAQ) and Global X China Consumer ETF (CHIQ), both from Global X Management Co. LLC.
Another way to help ensure local market exposure would be to focus on the smaller-cap products such as Wisdom Tree Emerging SmallCap Dividend ETF (DGS) from WisdomTree Funds, SPDR S&P Emerging Markets Small Cap ETF (EWS) from State Street Global Advisors, and Market Vectors Latin America Small-Cap Index (LATM) from Van Eck Global.
Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected]
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