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By Patricia Oey

In 2010, emerging-markets ETFs continued to grow, both in assets and in breadth of offerings. With the proliferation of more niche emerging-markets ETFs, investors should find it easier to build portfolios to better capitalize on specific investment ideas. In this article, we will discuss the 2010 performance of this asset class, highlight some of the ETFs that were launched in 2010, and identify some ETFs that we think would serve as good building blocks for emerging-markets exposure going forward.

Investors flocked to the capitalization-weighted emerging-markets funds iShares MSCI Emerging Markets Index (NYSEARCA:EEM) and Vanguard Emerging Markets Stock ETF (NYSEARCA:VWO) in 2010, making them the third and fourth most popular ETFs on the market, with more than $90 billion in assets combined. These funds provide exposure to about 20 countries and returned 16% and 19%, respectively, in 2010. While these funds outperformed the S&P 500, strong market returns in countries such as Peru, Chile, Thailand, Indonesia, and Malaysia (which saw returns between 30% and 50%) did not make a strong impact on the returns of EEM and VWO because of their relatively small weightings. Instead, the weak performance of some of China's and Brazil's (which account for 18% and 16%, respectively, in EEM's and VWO's portfolios) large-cap stocks weighed on the performance of EEM and VWO.

Investors who hold EEM or VWO and are concerned about their heavy exposure to China and Brazil equities can adjust their exposure by adding single-country funds to their portfolios. Alternatively, investors can simply build their own emerging-markets portfolio using single-country funds. IShares has the broadest offering of single-country ETFs, including funds for the larger markets as well as the smaller markets such as iShares MSCI Poland Investable Market Index (NYSEARCA:EPOL) and iShares MSCI South Africa Index (NYSEARCA:EZA). Other providers of single-country emerging-markets ETFs include Market Vectors, EGShares, Guggenheim, and Global X.

In 2010, a number of ETF providers launched small-cap, emerging-markets funds, such as Market Vectors India Small-Cap ETF (NYSEARCA:SCIF), EGShares India Small Cap (NYSEARCA:SCIN), and Market Vectors LatAm Small-Cap Index ETF (NYSEARCA:LATM). While the performance of capitalization-weighted funds tends to be dominated by a handful of large-cap names, small-cap funds are generally more diversified, with no one stock accounting for an outsized portion of the portfolio. In addition, emerging-markets large-cap stocks can also be large multinational corporations or commodity producers--these types of companies are more influenced by global economic trends.

Small-cap stocks, on the other hand, are generally better leveraged to domestic growth trends and tend to have heavier weightings in consumer names. For example, while cap-weighted funds iShares FTSE China 25 Index (NYSEARCA:FXI) and iShares MSCI Brazil Index (NYSEARCA:EWZ) were both up about 2% in 2010, small-cap funds such as Guggenheim China Small Cap (NYSEARCA:HAO) and Market Vectors Brazil Small-Cap ETF (NYSEARCA:BRF) returned 14% and 26%, respectively. In China, large-cap industrial and material companies turned in weak performance as the government attempted to tamp down a potential asset bubble following a surge in stimulus spending in 2009. In Brazil, mega-cap Petrobras (NYSE:PBR) (which accounts for almost 20% of EWZ) fell 20%-plus in 2010 because of its negotiations with the Brazilian government regarding the rights to extract deep-sea reserves. Conversely, small-cap China and Brazil funds performed much better because of less portfolio concentration in certain companies. As such, the performance of funds such as HAO and BRF better reflected the high single-digit GDP growth in both China and Brazil in 2010. However, we highlight that small-cap emerging-markets funds are highly volatile and are appropriate for investors with a higher risk tolerance.

In the coming year, we note a number of trends that should support emerging-markets equities. GDP growth for the larger emerging markets is expected to be strong--China and India are expected to grow at a high-single-digit rate, and Brazil at a mid-single-digit rate. Leaders in Russia and India have stated that they plan to sell stakes in large government-owned companies in 2011, which should help broaden the equity markets in these countries. We also expect to see a healthy IPO pipeline out of Brazil, as many smaller companies waited for the $70 billion Petrobras share sale, which took place in late 2010, to be completed. Strong growth in the large emerging markets should help drive demand and prices for commodities, which would benefit commodity-oriented economies such as Brazil, South Africa, Russia, and some of the smaller South American countries and Southeast Asian countries. Finally, extremely low interest rates in the developed world will likely continue to support strong fund flows into the potentially higher-returning emerging markets. In the near term, we are optimistic about large-cap China and Brazil stocks because of their attractive valuations, especially relative to their small-cap counterparts.

For long-term, broad exposure to emerging markets, we like WisdomTree Emerging Markets Equity Income (NYSEARCA:DEM) and WisdomTree Emerging Markets SmallCap Dividend (NYSEARCA:DGS). Both of these funds have better country diversification, relative to EEM and VWO, and better exposure to more domestically oriented sectors. Over the past few years, DEM and DGS have strongly outperformed EEM and VWO. We note that DEM and DGS have almost no exposure to China and India companies, as these companies do not meet the funds' inclusion criteria, but investors can gain exposure to those markets through single-country ETFs.

Another area within emerging markets that investors can consider is local currency government bonds. Two ETFs in this category were launched last year-- WisdomTree Emerging Markets Local Debt (NYSEARCA:ELD) and Market Vectors Emerging Markets Local Currency Bond ETF (NYSEARCA:EMLC). While this used to be a very high-risk asset class, as some countries ran high deficits and defaulted on their loans, many emerging-markets bonds are now investment-grade, thanks to improvements in economic and financial policies, growing currency reserves, and greater central bank independence. These funds are currently yielding about 5% and may also benefit from the potential rise of emerging-markets currencies against the U.S. dollar.

While emerging-markets equities have performed strongly over the past two years, we remind investors that this asset class is about 50%-60% more volatile than U.S. equities and that some of the niche emerging-markets ETFs are likely to be even more volatile. One general risk to the emerging markets in the near term is the ongoing strong fund flow into the asset class, which could lead to a bubble. We advise investors to consider their risk tolerance before making any significant emerging-markets additions to their portfolios.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Trends in Emerging-Markets ETFs