The main reasons to invest in emerging market ETFs are exposure to higher growth countries and diversification. However, many emerging market governments attempt to keep their exchange rate with the dollar stable in order to encourage trade. This policy essentially levers these countries to the US’s monetary policy and the actions of the Federal Reserve. This relationship has been on full display in the last year, starting with taper talk in the spring and culminating in September’s no-taper announcement.
By tying monetary policy to the US via exchange rates, EM countries (EEM) have increased correlation with US equities (SPY). Asset allocation should be focused on finding uncorrelated exposure to growth and income. As correlation increases, the benefits of diversification decrease.
The central banks of Indonesia (IDX) and Brazil (EWZ) both raised their policy rates in response to taper talk in order to stabilize their exchange rates. Their performance is in contrast to South Africa (EZA), which chose not to tighten policy and saw significant outperformance over the summer.
The main takeaway is that not all EMs are the same and investors should consider the exchange rate policies of countries before investing. For emerging market exposure that is less correlated with the US, focus on countries that have more independent monetary policies, such as South Africa.
Also, be sure you have exposure to non-US developed markets as well, such as the UK, EU, Australia, and New Zealand. All developed market economies have independent monetary policies which insulate them from economic woes outside their borders.
© 2013 Market Realist, Inc.