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How investing in emerging markets differs from developed markets

Emerging markets correlation with US 2013-03-09Enlarge GraphInvesting in emerging markets is inherently different from investing in developed markets

The U.S. equity market is currently at $17 trillion, of which approximately $250 billion are in emerging market ETFs. These focused ETFs provide investors with a valuable tool to get exposure to equities in emerging countries without the complexity of investing directly in individual local equities.

The largest emerging markets focused ETFs are iShares’ MSCI Emerging Markets Index Fund (EEM) and Vanguard’s Emerging Markets ETF (VWO). There are other country specific ETFs, such as China (FXI), Hong Kong (EWH), India (EPI), Russia (RSX), Brazil, (EWZ), Mexico (EWW), to name a few. There are also other region focused ETFs, such as Latin America (ILF), Africa (AFK) and Asia (GMF), among others.

There are several risks and benefits to consider when investing in emerging market equities. Below we outline the key ones.

Currency Risk

One of the key risks of investing in emerging markets is currency risk. When investing in equities denominated in a foreign currency, there is downside risk that the local currency depreciates versus the investor’s domestic currency, which lowers the total return for the investor. This is because the investors needs to convert dollars to the local currency to purchase the local equities and then convert back to dollars when cashing out. The risk is not always negative; many emerging markets have seen their currencies appreciate versus the dollar as their economies and stock market grow and develop.

Diversification

Diversification of Emerging vs Developed Markets 2013-03-09Enlarge Graph

Investing in emerging markets has the inherent advantage of providing diversification of portfolio returns. This arises from the fact that the correlation, or dependence, between the emerging markets and the U.S. is much lower than with developed markets. The main reason for this is that aside from global economic conditions, these markets have country specific conditions driving their growth as their economies mature. The graph above shows that the correlation of emerging markets with the S&P 500, when compared with the U.S., is lower than developed markets.

The benefits are even larger when investing in frontier markets (e.g. Vietnam), which are much less developed stock exchanges in emerging markets. Global equity markets are inevitably interlinked given that while markets are local, the investor base is global. For this reason, even small differences in correlation, as the ones shown above, can help an investor diversify his or her equity holdings. An even more effective diversification tool is to invest in emerging markets debt (e.g. EMB) since the correlation between bonds and equities is much lower than that between developed and emerging markets.

Expected Return

Emerging markets, given their developing nature, usually enjoy higher growth rates than developed markets as they accelerate to catch up to mature markets. For this reason investing in emerging markets will not only diversify returns, but will add a source of returns with a higher expected return. The flip side is that since the emerging market’s investor base has large U.S. and global investor components, returns during downturns can be much more volatile. There is no free lunch, if a market offers a higher return it is because it is riskier or because international investors do not know as much as locals, but the latter efficiencies are becoming more rare at the country level.

As the markets become more liberalized and integrated (i.e. become more open to foreign investment and trade), the expected return starts to fall, but the process takes years; in time new emerging markets come onto the investors’ radars. Ten years ago no one would have thought Brazil and India would have grown to their current market sizes, and it would have been highly unlikely for a retail investor to consider investing in Indonesia or South Africa.

Valuation

Emerging Markets Valuation 2013-03-09Enlarge Graph

The advantage of the added volatility in emerging markets is that investors may be able to time their entry and exit into the markets based on historical and relative multiples. Multiples are a useful tool for gauging valuations level in a market. The most commonly used multiple is the P/E ratio, or share price to earnings per share ratio. The graph above shows the P/E ratios for several emerging markets. The data shows that Mexico is currently trading at rich valuations and that Brazil is probably at a good entry point right now.

Liquidity

Liquidity is a concern for direct investors in emerging markets. Many companies in emerging markets have smaller caps than in developed markets, and in many cases the percentage of publicly available shares can be as low as 10%. This is due to several factors. One is that many large public companies are still owned by sole individuals or families who control most of the shares; as the markets develop, the “float” or publicly available shares of companies increases. The second reason is that in several emerging markets, many companies own shares in other companies; in the case of conglomerates they own shares in each other, accumulating a large amount of cross holdings that make the true float available to investors much smaller.

Despite these limitations, investors in emerging market ETFs mainly need to worry about their ETFs liquidity, which is measured as the bid-ask spread. The bid-ask spread of EEW and VWO (the largest emerging market ETFs) is just a penny, so the trading costs for the retail investor are low. It is true that the reduced liquidity may increase trading costs for the fund manager which will reflect as implicit costs and hence lower returns for the ETF investor, but that is inherent in investing in emerging markets; emerging market focused ETFs usually track indices of the most liquid securities to minimize these costs. In other words, there is not much the end investor can do about the underlying liquidity of the shares traded, except for comparing the total returns, costs, and fees associated with the ETF versus the benchmark or underlying index.

Industry Concentration

Emerging Markets ETFs Industry Concentration (<a href='/quote-page/eem/'>EEM</a>) 2013-03-09Enlarge Graph

While emerging economies may be as diversified as developed economies, usually the publicly listed companies are concentrated in Financials, Technology, Basic Materials and Energy. The reasons for this is that the financial services companies are generally the most financially sophisticated and may be large conglomerates holding other businesses. The outsourcing of technology manufacturing to emerging markets results in large technology exposure. The large commodity exposure (mainly metals, mining, oil and gas) of emerging markets trade are the cause of the energy and materials exposure.

Regional Concentration

Emerging Markets ETFs Regional Concentration (<a href='/quote-page/eem/'>EEM</a>) 2013-03-09Enlarge Graph

ETFs tracking emerging markets in general are usually market cap weighted, which leads to a concentration on the largest markets, such as China and Brazil. Additionally, Asia’s emerging market stock exchanges are much larger than others in the world, which leads to concentration of almost 50% in Asian equities. Other regions, namely Latin America (excluding Brazil) and Africa are under-represented. Another problem with this concentration is that China has a very large influence over Asian equities, so diversification benefits are diminished.

A recent example of how this can affect investors was late last year when Apple’s (AAPL) price fell triggering a chain reaction which saw Foxconn, along with several other Asian suppliers, dropping in price, bringing down their respective country’s technology sectors and overall indices. It is worth noting that VWO, unlike EEM, has changed its reference index and by end of 2013 will have phased out its 14% exposure to South Korea, bringing down its Asian exposure.

ETF Investing Options

Given the above concentration issue, it is advisable to complement investing in global emerging market ETFs (e.g. EEM, VWO) with other regional and country ETFs to balance the exposure (e.g. ILF and GML for Latin America, EWW for Mexico, TUR for Turkey, RSX for Russia, EZA for South Africa, etc.). Bullish investors working specifically in these major markets can choose to invest solely in country ETFs (e.g. FXI for China, EWH for Hong Kong, EWZ for Brazil). In several emerging markets there are a number of options that allow the investor to focus on small cap companies (EWZS, BRF for Brazil, HAO for China or RSXJ for Russia) or on specific sectors (BRAF for Brazil financials or CQQQ for China technology). There are even ETFs that offer currency hedged options for investors concerned with currency risk (e.g. DBEM for general emerging markets or DBBR for Brazil).

Conclusion

In summary, emerging markets focused ETFs offer a great opportunity for investors to diversify their holdings and tap into additional sources of returns. In future articles we will cover follow-up topics such as cross-market correlations, fees versus returns, and regional and country level structural changes.