"So tell me what you want, what you really really want..." -- Spice Girls' "Wannabe"
Last August, I created my Gold Star Portfolio -- a collection of low-cost mutual funds that have demonstrated exceptional long-term performance. I identified good funds for four major categories of asset allocation:
- U.S. Large Cap,
- U.S. Small Cap,
- Foreign, and
A healthy diet includes the four basic food groups, but also a range of foods within each group. For example, carrots are great for you, but you should also have green leafy vegetables, too, like swiss chard.
Similarly, a healthy portfolio diversifies each category into a range of investments. For example, in the Foreign section of your portfolio, you might want to have some exposure specifically to emerging markets as well as the more industrially developed nations.
Emerging markets are countries that are undergoing tremendous growth, especially in the creation or expansion of a middle class. Think China and India. They also have the tendency to fall apart due to political instability and can have relatively immature financial markets with currency fluctuations and less-than-transparent business transactions.
I recently wrote about different ways you can invest in the so-called BRIC-nations: Brazil, Russia, India, and China. But to cover the broader emerging market category, I want to also look beyond these four nations.
Emerging Market Mutual Funds
I went looking for a good emerging market mutual fund that met the Gold Star criteria:
- have an overall Morningstar rating of five stars,
- have a five-star rating for the last three, five, and ten-year periods,
- are no-load funds,
- require less than $3,000 initial purchase,
- average tenure of the fund’s managers is greater than five years,
- have >$100M in assets, are open to new investors, and
- are available at either Schwab, Fidelity or E-Trade for no transaction fee (NTF).
Alas, there a no emerging market mutual funds that meet these stringent criteria. This isn't particularly surprising, as only about 1 in 1,000 mutual funds meets the Gold Star Criteria, and there are only 328 emerging market mutual funds listed by Morningstar. So, I gradually relaxed the criteria to find the best emerging market mutual funds, with a view towards long-term performance.
I was excited by the performance data of the DFA Emerging Markets Fund (DFEMX) and Dreyfus Emerging Markets (DRPEX). Then I realized that neither are available for individual brokerage accounts through Schwab, Fidelity or E-Trade.
Emerging Market Exchange Traded Funds (ETF's)
Dismayed by the lack of performance in emerging market mutual funds, I looked to ETF's. A primary difference between mutual funds and ETF's is that mutual funds are actively managed by team of investment professionals who strive to find the best investments that meet their fund's objective. A true ETF holds the investments of a specific index, for example, the 500 stocks of the S&P 500. Its performance never exceeds the benchmark, it exactly matches it, except for a small management fee. Because ETF's do not have the expense of stock-picking, they usually charge much lower fees than managed funds. Mutual funds that specialize in foreign investments typcially have higher expenses than domestic funds, because they have higher expenses to investigate and manage worldwide investments, and transaction fees are higher due to currancy exchange expenses.
A second difference between ETF's and mutual funds is that net asset value of a mutual fund is only calculated once a day, at the end of business. Therefore, mutual funds can hold positions in fairly exotic investments. ETF's are traded continuously throughout the day, thus then tend to consist of things that also can be priced continuously. Foreign ETF's usually consist of American Depository Receipts (ADR's). ADR's mimic the share value of foreign companies but are traded on American exchanges in American currency. Only the largest foreign companies offer ADR's, thus emerging market ETF's only offer the "blue chip" investments of the emerging market offerings. Since emerging markets represent potentially volatile investments, selecting an ETF seems like a simple way to select only the larger (and presumably more stable) components of a volatile sector.
Yet another difference is the way that mutual funds and ETF's are traded. Mutual funds are sold by the fund companies through brokerages, but each brokerage only offers funds from some of the companies. If you like a particular mutal fund, you have to hope that your brokerage covers it, or you might have to open another brokerage account elsewhere if you really want to hold it. On the other hand, ETF's are traded like stock. All brokerages sell all ETF's, but, like stocks, they charge a transaction fee for every sale and purchase*. If you are making a relatively large investment, say $10,000, and your transaction fee is $20 then one round-trip of a buy-and-sell will set you back 0.4%. If, however, you're making a $200 monthly investment, then that $20 transaction fee is taking 10% off the top. Ouch.
To summarize the difference between mutual funds and ETF's for emerging market investments:
- Mutual funds are actively managed and tend to charge higher expense ratios. For emerging market funds, annual fees of 1.5-3.0% are not uncommon. ETF fees can be as low as 0.16%.
- Foreign ETF's usually consist of ADR's, which, for emerging markets, are the largest (and presumably most stable) investments.
- ETF's are easier to buy and sell than mutual funds since every brokerage offers every ETF (unlike mutual funds); however, there is a transaction fee for every purchase and sale of an ETF, just as there is for buying or selling shares of stock.
Emerging Market ETF Selection: ADRE
After a little investigation, there seem to be a few good choices in this category, but BLDRS Emerging Markets 50 ADR Index (NASDAQ:ADRE)** stands out for its solid performance and low expense ratio (0.16%). InvescoPowerShares maintains a list its holdings on its website. It currently has a five-star rating from Morningstar, which I don't understand, because an ETF (or mutual fund) should rate exactly three stars if its performance matches its benchmark.
Comparing ETF's and Mutual Funds on Morningstar's website
I wanted to compare the performance of the ETF (ADRE) to the mutual fund (MUTF:DRPEX). At Morningstar's website, much to my horror, if you graph the performance of an ETF and then compare it to a mutual fund, it does not include the reinvestment of capital gains, and the chart is considerably misleading, as is shown below. All those horrible steps down in the yellow line at the end of each year merely represent distributed dividends and capital gains. The investor didn't really lose value, and the fair comparison is to assume that the distributed value is reinvested.
If instead, if you tab first to the mutual fund section, enter the mutual fund name and then compare it to the ETF, then it does present the data correctly, as shown in the graph below. So by entering the data in the opposite order, you get a completely different picture.
I've seen this problem before at other financial websites, but I had always relied on Morningstar to get it right. My faith is shaken.
For a solid investment in emerging markets, I had to look beyond conventional mutual funds. I found a solid ETF in BLDRS Emerging Markets 50 ADR Index (ADRE). ADRE has a low expense ratio (0.16%) and has slightly outperformed its index over the last seven years. Emerging markets are more volatile than other types of investments, so they should only represent a small fraction of your portfolio, typically 2-10%.
*Schwab recently began offering no-transaction fee ETF's to its clients. Later this month they are slated to offer a no-transaction fee ETF for emerging markets (NYSEARCA:SCHE) with and expense ratio of 0.35%
**BLDRS = Baskets of Listed Depository Receipts
Diclosure: No positions in any of the above-mentioned funds or ETF's, though I do plan to invest in ADRE.
Disclaimer: This information is provided for educational purposes only. It may not be an appropriate investment for you. Learn all you can about investing before plunking your money down. Investments in mutual funds and/or ETF's are not FDIC insured and can cause loss of principal. (You can lose money).
Disclosure: Currently, no positions in any of the funds mentioned, though I plan to make a modest investment in ADRE.