Time To Up Your Allocation To Emerging Markets

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 |  Includes: EEM, VWO
by: Alan Brochstein, CFA

Investing in emerging markets is quite appealing to me conceptually, but it's an idea that hasn't worked very well over the last couple of years. Why invest? The experts used to say diversification, but, in this increasingly 'global' world, markets are highly correlated. While the stock prices do tend to track the S&P 500 (NYSEARCA:SPY) more closely than historically, currency changes result in more divergence of returns. Quite simply, owning the emerging markets currencies can, like owning developed currencies, hedge against a declining dollar. But one can accomplish this type of diversification simply by investing in foreign currencies.

Rather than diversification, I have viewed emerging markets as a likely alpha generator. In a world starved for growth, the growing middle classes in countries like Brazil and China can generate internal real growth as living standards rise. Plus, these countries tend to have much better balance sheets than the governments of the developed countries. While the growth has been higher than in the developed world, it hasn't been particularly strong. One of the inhibitors was that the central banks were raising rates as late as 2011, trying to keep their economies from overheating. This tight monetary policy came to a stop, but the damage was done. Additionally, many of the emerging countries enjoy net exports, and the slowing in Europe has taken a toll. Finally, poor liquidity for stocks globally had a negative impact on emerging markets stocks, especially since the summer of 2011. All of this has left the stocks seemingly cheap, trading at about 10 PE on a forward basis and 1.6X book value according to MSCI.

The tide has turned, though, and I think that the long-term bull story is likely back on track this quarter. MSCI divides the world into developed, emerging and frontier, and the 21 countries that comprise the emerging category include: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey. Speaking of Turkey, it is sailing this year. Seeking Alpha has a great page that helps us quickly evaluate how it and most of the other countries that are considered emerging markets are doing. As I type, the ETF for Turkey, the iShares MSCI Turkey (NYSEARCA:TUR) is up 60% YTD. There are several other countries whose dollar returns exceed 20%: Mexico, Thailand, Hong Kong, Colombia and Singapore. Brazil is the only decliner. The MSCI index is up 12.9% in dollars YTD through December 11th, a little less in local currencies (12.1%) as the dollar has weakened slightly.

While I am primarily a stock-picker, I find the ETFs (or perhaps a mutual fund alternatively) as the likely best way to invest in emerging markets, as I have more than enough domestic individual companies to follow already! Kidding aside, a diversified portfolio of companies allows one to avoid the risks of picking the wrong company or country and of having to deal with local currency issues and potential tax headaches. The problem is that the ETFs aren't so great. Let's look quickly at the two leading ones, which include the Vanguard Emerging Markets fund (NYSEARCA:VWO) and the iShares MSCI Emerging Markets Fund (NYSEARCA:EEM). They are a lot more similar than they are different. First, let's look at the long-term performance of EEM, which has a longer history, as well as SPY:

(click to enlarge)Click to enlarge

The top panel is the longest in nature and certainly demonstrates longer-term dominance of emerging markets relative to the U.S. stock market coming out of the 2001-2002 bear market. The middle panel (and the bottom one) shows that over the past five years, the two have moved in sync, with underperformance of the emerging markets since the summer of 2011. The final panel highlights recent outperformance in 2012 following underperformance from February, with the summer again proving to be the lows for the year.

VWO, according to the ETFdb, has $58 billion in assets (larger if the institutional ETF is included) and a 0.2% expense ratio. The ETF holds 888 stocks, with the top 10 representing 14% of the fund. China is 18%, followed by South Korea (14.5%), Brazil (12%) and Taiwan (11%). They characterize only 11% as not "giant" or "large" companies. Financials represent 22%, Technology 14%, Materials 12% and Energy 11%.

EEM, according to BlackRock (which owns iShares),has $43 billion in assets and a 0.67% expense ratio. The ETF holds 843 different securities. Financials are 26%, while Materials, Energy and Technology range from 11-14% each. China represents almost 18%, while South Korea is 15% and Brazil is 13%. The top 10 holdings represent 16% of the ETF and include very large companies.

So, investing in emerging markets through VWO or EEM means making a bet on very big companies as well as sector weightings that are quite extreme. There are other ETFs, with most focusing on different regions and some, from iShares, focused on different sectors. For instance, one can invest in an emerging markets fund that holds only Consumer Discretionary companies, iShares MSCI EM Consumer Discretionary Sector Fund (NASDAQ:EMDI). Interesting but impractical, as it trades on appointment, averaging less than 2000 shares per day since its launch this year. One concept that answers my concerns about the large-cap nature of VWO and EEM is the SPDR S&P Emerging Markets Small Cap (NYSEARCA:EWX) and the similar iShares MSCI Emerging Markets Small Cap Index Fund . Seeking Alpha author Tom Lydon shared an interesting perspective recently. I intend to study these more closely, as there may be better long-term alpha generation, but it looks like there is a fairly big liquidity cost. For long-term investors, this likely isn't a big impediment.

I have had a fairly high exposure in my Sector Selector ETF model portfolio since inception (in April 2011), but I just increased it earlier this week to close to the maximum exposure allowed for international stocks. So far in Q4, VWO is up 4%, while SPY is flat. This near-term momentum leaves the two virtually tied in 2012. I expect that the returns over the next few years should prove substantially higher than the S&P 500. Not only are the fundamentals favorable, but the valuation is quite low. So, whether its increasing exposure to U.S. companies that cater to emerging markets or directly investing in them through ETFs or funds, I think that this is a great time to once again embrace this solid long-term investment idea.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long VWO in one or more models managed by the author at Invest By Model