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A quick look at the headlines on any given day is generally enough to explain why investors have been shifting greater percentages of their long-term portfolios towards emerging markets in recent years. The U.S. is grappling with elevated unemployment, and faces a regulatory gridlock that is creating undesirable tax uncertainty. Europe has been unable to address a spreading debt crisis that is now threatening the very survival of the currency and seems likely to eventually cause billions in sovereign defaults. Japan, though showing some signs of life, is still mired in a decades long slump that has only been exacerbated by natural disasters.

While advanced economies are facing some stiff headwinds, emerging markets continue to expand their presence on the global economic stage and ride demographic tailwinds to a red hot rate of GDP growth. The Chinas and Indias of the world certainly have their fair share of issues; inflation is an immediate concern, and the political risk in some emerging markets is a meaningful factor. Beyond the short-term issues, however, is tremendous long-term potential; the BRIC is expected to keep up solid growth rates for decades to come, maintaining a sizable edge in pace of expansion over developed economies for the foreseeable future.

It’s also pretty easy to explain why more and more investors are embracing exchange-traded funds as a way of achieving exposure to emerging markets. The marriage of the promise of the asset class with the transparency, cost and tax efficiency, and unparalleled liquidity of the exchange-traded structure, investors are able to enhance their portfolio is a combination that is tough to beat, especially for advisors and individuals focusing on the long run.

The first broad-based emerging markets ETF debuted more than nine years ago; in the time since, innovation in this corner of the market has given investors looking to tap into this asset class a number of options from which to choose. There are now about two dozen broad emerging markets ETFs, and many more that offer sector-specific or country-specific access. While these products may be generally similar, there are nuances to each that can be the difference between mediocre and stellar returns. Below, we highlight some factors that are worth considering when evaluating emerging markets ETFs:

1. The “Quasi-Developed” Conundrum

To many advisors and investors, emerging markets likely conjure up images of China and India–developing economies that are drastically different from the U.S. in terms of per capita GDP, literacy rate, and other indicators of human development. That is often in contrast with the countries that actually make up emerging markets ETFs, which generally maintain hefty allocations to countries such as South Korea and Taiwan. Because some index providers have determined that those countries are still emerging, many of the products in the Emerging Markets ETFdb Category don’t have quite the “pure play” exposure to truly emerging economies that one might suspect.

Here’s a quick illustration; the following table shows four key metrics, per capita gross domestic product, literacy rate, life expectancy, and Human Development Index (HDI) scores. Take a look, and determine which are emerging and which are developed.

Country Per Capita GDP Literacy Rate Life Expectancy HDI Score
Country 1 $29,997 99.0% 79.1 0.897
Country 2 $35,604 96.1% 78.3 0.868
Country 3 $29,480 98.9% 80.5 0.874
Country 4 $11,273 90.0% 72.4 0.718
Country 5 $7,544 95.9% 73.5 0.687

Here’s the same table with the country names filled in, revealing that South Korea and Taiwan are in many ways more advanced than one of the world’s largest developed markets:

Country Per Capita GDP Literacy Rate Life Expectancy HDI Score
South Korea $29,997 99.0% 79.1 0.897
Taiwan $35,604 96.1% 78.3 0.868
Italy $29,480 98.9% 80.5 0.874
Brazil $11,273 90.0% 72.4 0.718
China $7,544 95.9% 73.5 0.687

So keep an eye on how much emerging markets exposure you actually have; depending on your classification system, it might not be as much as you think. For investors looking for pure-play emerging markets exposure, the GEMS Composite ETF (NYSEARCA:AGEM) might be worth a closer look; this fund from EGShares excludes the “quasi-developed” economies, and focuses instead on the BRIC bloc and markets such as South Africa, Mexico, Chile, and Indonesia.

2. Big Differences In Fees Go A Long Way

Most advisors are aware that while all ETFs are generally cheap compared to active mutual funds, the cost efficiency can vary from product to product. The best example of this is perhaps in emerging markets ETFs, where annual management fees can range from about 20 basis points to nearly 100. That’s a huge range, and one that can translate into big dollar differences.

To drive home this point, suppose that the MSCI Emerging Markets Index gains 6% annually for the next 30 years, and that neither EEM or VWO experience any tracking error. An investor who puts that $1 million in EEM (expense ratio of 0.68%) would have $4.7 million at the end of that period–a nice gain. That same investment in VWO (which charges just 0.22%) would result in an additional $700,000 or so–a sizable gap that illustrates what has been called the “tyranny of compounded costs.”

The cheapest emerging markets ETFs are the Vanguard MSCI Emerging Markets ETF (NYSEARCA:VWO), iShares Emerging Markets Minimum Volatility Index Fund (NYSEARCA:EEMV), and the Schwab Emerging Markets Equity ETF (NYSEARCA:SCHE). ADRE, which debuted back in 2002, isn’t far behind at 0.30%.

Of course, fees should not be the only consideration in this process, but the big gap in this category makes this metric worth a closer look.

3. Rounding Out Exposure

U.S. investors now have access to just about every major global economy through exchange-traded products; even smaller markets such as Chile and Ireland are now represented by their own ETFs. Many of the “first generation” of international equity ETFs seek to represent a significant portion of the public market cap for the underlying economy, an objective which necessarily requires a significant tilt towards large cap companies.

As a result, the emerging markets allocation in many portfolios is skewed toward large cap banks and oil companies, with little in the way of small/mid caps or towards frontier markets that may offer additional return potential. Fortunately, there are a number of useful tools for those looking to achieve more balanced, well-rounded emerging markets:

  • SPDR S&P Emerging Market Small Cap ETF (NYSEARCA:EWX)
  • MENA Frontier Countries Portfolio (NASDAQ:PMNA)
  • IQ Emerging Markets Mid Cap ETF (EMER)

It’s also worth noting that EGShares offers a suite of sector-specific emerging markets ETFs that can be used to construct a more balanced emerging markets position. For example, many popular emerging markets ETFs are tilted towards the financial, materials, and energy sector, with little in the way of exposure towards health care or utilities. For investors who believe those corners of the market should receive a bigger representation, products such as the Utilities GEMS ETF (NYSEARCA:UGEM) and Health Care GEMS ETF (NYSEARCA:HGEM) might be useful tools.

4. Watch The Weight

While the most popular emerging markets ETFs are linked to market cap-weighted benchmarks, innovation in the ETF industry in recent years has given investors a number of alternative for tapping into core asset classes using slightly different approaches for determining company-specific allocations. While the development of these alternative weighting methodologies took place first in the domestic equity space, it has now spread to emerging markets as well. For those looking to steer clear of traditional cap-weighted approaches, there are a number of different options:

  • MSCI Emerging Markets Equal Weight ETF (NYSEARCA:EWEM): Assigns an equal weight to each component
  • FTSE RAFI Emerging Markets Portfolio (NYSEARCA:PXH): Uses four fundamental measures of firm size
  • Low Volatility Emerging Markets Dividend ETF (NYSEARCA:HILO): Weights components based on dividend yield
  • Emerging Markets Equity Income Fund (NYSEARCA:DEM): Linked to an index that includes the highest dividend yielding stocks from emerging markets

5. Currency Exposure: To Hedge Or Not To Hedge?

While we generally think of investment in emerging markets ETFs as a long position in the underlying stocks, these securities generally offer currency exposure as well–meaning that investors are long in the currencies of these countries relative to the U.S. dollar. Most investors establishing a position in emerging markets stocks will be happy to take on exposure to the currencies of these economies as well. As the prominence of emerging markets on the global stage increases, it follows that these currencies should generally appreciate relative to the U.S. dollar–although there can be significant volatility along the way. But for those who prefer to strip out currency exposure from their portfolios, there is an ETF that can isolate only the stock components.

That would be the MSCI Emerging Markets Currency-Hedged Equity Fund (NYSEARCA:DBEM), which consists of the same stocks that make up EEM and VWO, but uses forward contracts to strip out any exchange rate-related movements. It might seem like a minor difference, but the impact on bottom line returns can be significant. When the dollar strengthens, which it usually does in turbulent environments, DBEM should generally deliver better results.

This article is a free preview of our Special ETF Research Report for November 2011, Analyzing Emerging Markets ETFs.

Disclosure: No positions at time of writing.

Disclaimer: ETF Database is not an investment advisor, and any content published by ETF Database does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. From time to time, issuers of exchange-traded products mentioned herein may place paid advertisements with ETF Database. All content on ETF Database is produced independently of any advertising relationships.

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Source: 5 Factors To Consider In Choosing An Emerging Markets ETF