Don't Let Your Emerging Market Position Catch a Cold

by: Common Cents

There is an old saying in the world of global investing: "When the U.S. sneezes, the world catches a cold." Today, the U.S. is still recovering from a cold and U.S. consumers do not appear to be the engine of growth they once were.

On the other hand, the huge population in China that is moving towards the middle class is a key driver of global demand. Hence, it seems that "When China sneezes, the world catches a cold” may be the more relevant saying today.

The current news cycle is full of concern over unrest in the Middle East and its impact on oil prices. This situation can have implications for the global economy, and may be pushing China headlines to the background, but there are still plenty of opinions about the future of China and its long-term prospects for investing.

However, it is not to hard to believe that China could also encounter economic headwinds in the short-term. That can happen in a lot of ways, including: Social unrest, excessive inflation, the Chinese government's intervention in its economy hits some snags; the U.S. and/or others get protectionist; Korean peninsula tensions escalate; or just normal business cycles lead to a slowdown in growth.

Many investors who believe in the emerging middle class of China try to capitalize on this story via investment vehicles such as:.

  • Chinese ETFS such as FXI.

  • Chinese IPOs.

  • Broad-based emerging markets funds – EEM and VWO are two of the largest such ETFS, with over a quarter of their assets in Chinese and Taiwanese markets.

  • Multinational, industry-leading companies in the developed world that the Chinese government is using to bring in today's product solutions and to share the technology for the future.

Who knows what the future holds, but there is at least some probability of some sort of hick-up in China in the reasonable future. If that happens, what happens to the investments approaches above?

  • Chinese-based ETFS and IPOs obviously suffer a direct hit if China sneezes.

  • Broad-based emerging market ETFs' significant direct investments in China or Taiwan and other direct-trading partners also suffer a near-direct hit.

  • Large multinationals might be able to offset any adverse impacts from China in other parts of the world. However, a lot of these companies have a big stake in China and will likely be adversely impacted in some way.

Protective medicine from a China slowdown for an emerging market portfolio might be achieved by looking at other places in the world where large populations are moving to the middle class but that have a different set of macro level drivers.

There is at least one ETF that has tried to address this issue directly.

  • ECON, the Emerging Market Consumer from Egshares, invests in “leading emerging market companies in the Consumer Goods and Consumer Services Industry." These companies should benefit directly from an emerging middle class, yet only about 6% of the fund is in China. Mexico is the largest country concentration in this ETF.

This ETF seems like a good way to get exposure to the emerging middle class while being less dependent on China. However, it seems to have minimal exposure to two of the largest markets where lots of people may be emerging into the middle class: India and Brazil. One approach to adding more exposure to the emerging middle class of these markets would be to invest in small-cap stocks in both. Two ETFs provide an opportunity to invest in the small-cap stocks of these countries:

  • BRF seeks to replicate the Market Vectors Brazil Small Cap Index.

  • SCIN seeks to replicate the India Small Cap Index. This fund is new and has limited operating history and liquidity.

An investor can mix and match these three ETFs to get an investment mix with which they are comfortable, but one potential blend of these funds would be 50% ECON, 25% BRF, 25% SCIN. I'll call that mix of ETFs EEM-2. EEM-2 consists of over 160 stocks with nearly 2/3 of them consumer oriented. Brazil and India each represent about 30% of EEM-2, with Mexico at 11%, South Africa at 10%, Chile 6%, Malaysia 4% and China less than 3% of the holdings.

These ETFs are relatively new, so it is difficult to back-test their performances. I plan to start tracking the performance of EEM-2 on my blog.

Obviously, these markets can be risky. However, if an investor has decided to include some emerging market risk/reward in his portfolio, this different blend of stocks and countries does provide extensive exposure to the trend of an emerging middle class. This combination of ETFs would seem to be less impacted by a Chinese slowdown and have a low correlation to traditional emerging market ETFs which are also heavily dependent on China.

Perhaps EEM-2 is just what the doctor ordered to keep your investments in emerging markets from catching a cold if China sneezes.

Disclosure: I am long ECON, BRF, SCIN.