During the global recession, equities in emerging nations declined more than those in developed nations. From its high in 2007 to the low in 2008, the iShares MSCI Emerging Markets Index Fund (NYSEARCA:EEM) declined 67% compared to the 62% decline in iShares MSCI EAFE Index ETF (NYSEARCA:EFA).
Since then, a large number of emerging nations have quickly recovered from the recession. The iShares MSCI Emerging Markets Index Fund needs to gain 22% to reach its 2007 high. In comparison, the iShares MSCI EAFE Index Fund needs to gain 39% to get back to its 2007 high.
The factors that have spurred the emerging markets recovery include their lower external debt, higher GDP growth prospects, and superior profitability of publicly traded companies. According to Invesco’s (NYSE:IVZ) PowerShares Connection March 2010 Report,
External Debt: The external debt burden of the emerging nations in the G20 group is 36% of their GDP while it is 327% of GDP for the developed nations in the G7 group.
GDP Growth Prospects: The GDP of emerging nations in the G20 group of nations is expected to grow 4.5% in 2010, while the GDP of the developed G7 group of nations is expected to grow 1.7%.
Company Profitability: Companies in the MSCI Emerging Markets Index have a Return on Equity (ROE) of 17.4%, which is well above the 12.2% ROE for companies in the MSCI EAFE Index.
Emerging Markets Investing Categories
Investors have four categories of ETFs to invest in emerging markets:
Broadly Diversified: The broadly diversified category includes large ETFs like Vanguard Emerging Markets Stock ETF (NYSEARCA:VWO) and iShares MSCI Emerging Markets Index Fund. PowerShares BLDRs Emerging Markets 50 ADR (NASDAQ:ADRE) offers a convenient means to invest in a basket of ADRs of emerging nations companies.
Thematic: Claymore/BNY Mellon BRIC (NYSEARCA:EEB) is an example of a thematic ETF focusing on the fast growing emerging markets of Brazil, Russia, India and China.
Country: iShares FTSE/Xinhua China 25 (NYSEARCA:FXI), iShares MSCI Brazil (NYSEARCA:EWZ), and iShares MSCI Mexico (NYSEARCA:EWW) are examples of ETFs available for investing in larger emerging markets. ETFs like Market Vectors Vietnam (NYSEARCA:VNM) are also available for investors seeking exposure to frontier markets.
Risks of investing in Emerging Markets
Investments in emerging markets carry risks, the important ones being political, economic, and concentration risks.
Political: Political crises arising from internal or external sources are not uncommon in many emerging nations. The current political unrest in Thailand highlights this type of risk. Such unrest can potentially disrupt the orderly functioning of Thailand’s financial market and impair the performance of iShares MSCI Thailand Index Fund (NYSEARCA:THD).
Economic: While the stimulus measures have helped economic recovery, nations like China and India are voicing concern over inflation. China has started to pare stimulus measures while India has raised interest rates. As pointed out in‘MSCI Emerging Markets Index: Eastern Europe Ain't China or India’, economies in Eastern Europe have been scathed by the global financial crisis and modest growth is expected in countries like the Czech Republic, Hungary, and Poland.
Concentration: The market-cap weighting methodology exposes some country ETFs to a high degree of sector or company concentration risk as stated in ‘ETF Holdings, Performance, and Risk: Will Your ETF Be Next to Blow Up?’. As an example, the iShares MSCI South Korea Index Fund (NYSEARCA:EWY) has invested nearly 19% of its assets in Samsung Electronics (OTC:SSNNF).
Considering the reward and risk profiles of the different investments described above, most individual investors would do well by limiting investments in emerging markets to about one-seventh of their total investable assets.
Investors can also use a core-satellite strategy with a broadly diversified ETF serving as the core to control volatility and a regional or country ETF serving as the satellite to enhance return.
Disclosure: I have long positions in EEB, EEM, EWW, and EWY. I do not have any positions in the other securities discussed.