Four Creative Ways to Beat the Most Popular Emerging Market ETF

by: Carl T. Delfeld

Investing in Asian and emerging market growth is likely to be the dominant theme of the next decade. One can, however, argue about the best strategy and tools to tap into this economic growth, demographic change and rise of the emerging middle consumer class.

But first let me make a point about America. My book, Red White & Bold: The New American Century, highlights America’s significant strengths and why I believe it will remain “first among equals” and deserves center stage in any global portfolio whether you live in Beijing, Chicago or Santiago. Another major theme of the book is that America and investors will only prosper by growing with Asia and emerging markets.

Sounds good but buying and holding the MSCI Emerging Markets Index through the popular iShares ETF (NYSEARCA:EEM) is a losing strategy (the same applies to Vanguard's VWO, which is the same index, albeit via a different indexing strategy). It may surprise you to learn that an investment at the founding of this index in 1986 and held on until today would be in the red.

Many investors do much worse than this example. Why? Because emerging market investing is a roller coaster with many unfortunately buying at the top and selling at the bottom. In addition, because the countries in the EEM basket are weighted by market cap, 57% of your money is going into five countries: Brazil, South Korea, Taiwan, China and South Africa. Is South Korea (NYSEARCA:EWY) a twenty times better investment than Peru (NYSEARCA:EPU)? Should you have ten times more exposure to Brazil (NYSEARCA:EWZ) than Turkey (NYSEARCA:TUR)? This is what you are getting if you use EEM for your emerging markets strategy.

Despite these flaws, many investors and advisors will continue to use EEM as a proxy for emerging markets largely because it is easy and convenient. It also leads to a substantial underweighting of emerging markets in most global portfolios. Emerging markets represent 83% of the world’s population, 34% of global GNP, 11% of the MSCI All Country index but according to Morningstar, only 2% of mutual fund and ETF assets.

For your global portfolio, instead of using the market value of a country’s stock market to weight asset allocations, why not use their share of global GDP? This would lead to 28% of your portfolio going to America and Canada, 27% to Europe, 12% to developed Asia and 33% to emerging markets. My Global GNP 30 portfolio using this strategy has handily beaten the Dow or the S&P Global 100 over the last five years.

Here are some ideas how you can beat EEM taking a conservative, balanced, aggressive and offbeat strategy.

Since emerging markets tend to go to extremes, why not broaden your menu beyond just equities? Add some currencies (NYSEARCA:CEW), bonds (NYSEARCA:EMB), cash, and even some inverse ETFs (NYSEARCA:EUM) into the mix. Right now our Emerging Markets Balanced portfolio has about 50% exposure to equities, 30% to bonds and currencies and 20% to cash. This may well be too conservative but this mix over the last three years would have beaten EEM.

Another strategy might be to weight emerging market countries equally in a portfolio rather that just accepting the top-heavy approach of EEM. Our Emerging Market Equal Weight portfolio using country ETFs has done surprisingly well beating EEM by a nice margin over the last one-year and three-year periods.

You can take this shuffling the deck strategy to shift towards a more aggressive country weighting. Instead of leaning towards the BRIC countries, why not tilt towards countries like Indonesia (NYSEARCA:IDX), Turkey (TUR), and Russia (NYSEARCA:RSX). A basket of ten of these countries equally weighted in a portfolio has beaten EEM like a drum over the past year and three years without breaking a sweat.

Finally, many investors interested in emerging markets are held back by their wariness or antipathy towards China. Why not just take China out of the equation? Our Emerging Markets ex-China portfolio has beaten EEM over the last one-year and three-year periods as well.

Show some creativity and flexibility and build a portfolio that more effectively captures emerging markets growth.

Disclosure: Author owns all ETFs mentioned in this piece except EPU and VWO.