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By Patricia Oey

Last month, I wrote an article entitled Are Emerging Markets Cheap? to shed some light on some of the assumptions that underlie the opinion that emerging markets are trading at attractive valuations. As a follow-up, and to address a number of reader requests, this article will focus on investment ideas in emerging markets. First, I will take a look at emerging-markets fund managers' recent purchases for some investment ideas that can be executed via exchange-traded funds. Then, I will discuss "quality" investing in emerging markets and highlight which ETFs may offer similar exposure. This article is not intended to illustrate how to replicate an actively managed strategy using ETFs but, instead, is meant to highlight investment ideas and themes from top fund managers.

The Buy Ideas
Indonesia is considered one of the "Fragile Five" emerging markets, but among the five, its government has been more proactive about addressing its current account deficit, first by letting its currency depreciate and then by raising interest rates. But during a fairly volatile fourth quarter, top Morningstar analyst-rated emerging-markets funds, including Harding Loevner Emerging Markets (HLEMX), JPMorgan Emerging Markets Equity (JEMCX), Lazard Emerging Markets Equity (LZEMX), and Oppenheimer Developing Markets (ODMAX) all boosted their holdings of Indonesian companies. These Indonesian purchases were one of the few discernible trends among top emerging-markets mutual funds. This is despite a muted near-term outlook and a fairly valued Indonesian equity market.

The risks to the performance of Indonesian equities in the near term include tighter credit conditions and a weaker rupiah, which may temper growth. There is also some policy uncertainty due to the upcoming national legislative elections in April and presidential elections in July--investors are waiting to see if the new administration will continue to liberalize foreign investor limits, which would be a catalyst for growth. However, the medium-term outlook for Indonesia remains healthy, with private consumption, a young population, and spending on infrastructure likely to be key growth drivers.

Despite recent declines, Indonesian equities are not cheap relative to their recent history--the MSCI Indonesia Index is trading at a forward price/earnings multiple of 13 times, which is close to its eight- and three-year averages. However, the P/E ratio does not reflect the value of the local currency versus the U.S. dollar. The Indonesian rupiah was one of the worst-performing currencies in 2013 and is still trading at about a 20% discount to where it was from 2010 through the first half of 2013. Any improvement in macroeconomic fundamentals should provide a lift to the depressed rupiah, and to any rupiah-denominated investment. So while the equity market may not be cheap, its currency may be undervalued.

Cap-weighted, single-country ETFs, particularly ones that invest in emerging-markets countries, are not always good investment options, as they can have significant concentrations in a few holdings or in a particular industry. However, iShares MSCI Indonesia (NYSEARCA:EIDO) is a reasonably diversified fund and is a suitable option for those bullish on Indonesia's medium-term outlook. The fund's largest sector weighting is in financials, which primarily includes banks with healthy balance sheets and good growth outlooks. The fund also has heavy exposure to consumer names. While these companies, such as auto distributors, personal care product companies, and packaged food producers, may face short-term headwinds due to a tighter credit environment and potentially higher input costs due to a weaker rupiah, they are exposed to long-term, secular growth in consumer spending.

"Quality" in Emerging Markets
As I scanned the portfolios and quarterly reports of the various emerging-markets funds for investment ideas, I noticed that a number of managers (see Table 1) highlight that they seek to invest in "quality" firms. As part of their investment process, they screen for companies that have one or more of the following characteristics: high returns on invested capital, sustainable competitive advantages, low debt, good management, and healthy free cash flows. These traits are fairly consistent with Warren Buffett's investment philosophy (as well as a new U.S. equity quality ETF, iShares MSCI USA Quality Factor (NYSEARCA:QUAL)), and more details on this topic can be found in my colleague Sam Lee's article Another Buffett-in-a-Box?

What is interesting to note is that while these five quality funds have consistently sat on the growth side of the Morningstar Style Box (thanks to their relatively high valuation multiples), they have provided absolute and risk-adjusted returns that were higher than the category average and both the MSCI Emerging Markets Index and the MSCI Emerging Markets Growth Index over the past 10 years.

There are a few reasons why quality funds tend to trade at higher multiples than the MSCI Emerging Markets Index. First, the MSCI Index holds many large-cap government-controlled firms, which are generally less efficient and trade at lower multiples. Second, quality funds tend to invest in companies that will benefit from rising living standards and that have good growth outlooks. Many of these companies are consumer and Internet firms, which generally trade at higher price/earnings multiples. It is also possible that in emerging markets, quality firms may carry a bit of a scarcity premium.

ETF Options for Quality Exposure
WisdomTree Emerging Markets Dividend Growth (NASDAQ:DGRE) and WisdomTree Emerging Markets Consumer Growth (NASDAQ:EMCG) are currently the only quality-focused emerging markets ETFs available. Both of these funds track indexes that screen for growth (as measured by long-term earnings growth expectations) and quality (as measured by the three-year historical averages for return on equity and return on assets). EMCG also has a valuation screen to prevent the fund from having a growth tilt.

A quick way to assess the "quality" of these WisdomTree funds is to compare their portfolios with those of the five funds in Table 1. To do this, I used Morningstar Direct to generate the data in Tables 2 and 3 below. In addition to the two WisdomTree funds, I included two low-volatility funds (iShares Emerging Markets Minimum Volatility (NYSEARCA:EEMV) and PowerShares Emerging Markets Low Volatility (NYSEARCA:EELV)), as low volatility can be a proxy for quality. I also included EGShares Emerging Markets Consumer (NYSEARCA:ECON), which is a concentrated portfolio of 30 emerging-markets consumer discretionary and consumer staple firms, and WisdomTree Emerging Markets Equity Income (NYSEARCA:DEM), which is the largest non-cap-weighted emerging-markets ETF and has a value tilt. The last column is data for the MSCI Emerging Markets Index.

To calculate this data, Morningstar Direct determines how many holdings any two funds have in common. In Table 2, the data table reflects what percent of the total portfolio of the fund on the vertical axis is represented by the common holdings. Table 3 is the figure for the fund on the horizontal axis. For example, for funds Oppenheimer Developing Markets and iShares Emerging Markets Minimum Volatility, there are 19 holdings in common (not included in the tables), which accounts for 15% of the Oppenheimer portfolio (Table 2) and 10% of the iShares portfolio (Table 3).

While this analysis is very simple, it does indicate that DGRE and EMCG are the better ETF options for quality in emerging markets. And although overlap in the 20% range between the WisdomTree funds and the actively managed funds does not sound like a lot, we note that the five actively managed funds overlap with each other in the range of 10% to 40%, in part because the emerging-markets asset class is so broad. ECON, due to its concentrated nature and single sector focus, has holdings that account for a small percentage of the actively managed funds (which are more diversified), but ECON does tend to hold many of the same consumer names as the actively managed funds. As for DEM, with its value tilt, it has low overlap with the actively managed funds. Finally, the MSCI Emerging Markets Index, because of its breadth (with 822 constituents), holds many of the companies held by the five funds (where common holdings account for an average 60% of the five funds), but within the index, these common holdings constitute a much lower 17% of the index’s portfolio.

While the portfolios of DGRE and EMCG appear to be well-diversified, it is difficult to predict how the portfolio will evolve over time. These funds (and their underlying indexes) have a very short operating history and have low assets under management (smaller funds tend to be unprofitable and run the risk of being liquidated). We recommend that investors who purchase these funds monitor the portfolio and performance very carefully.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Where Are The Opportunities In Emerging Markets?