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A Few Doubts That I Have Been Having Lately About Emerging Economy ETFs

The narrative of the emerging economies is certainly compelling, I have invested in emerging economies this year and have enjoyed the experience - the experience of making money.  

I am troubled however by phenomena that I have been observing over the past few months of fairly intense scrutiny of available information for emerging economy ETF investing, the kind of things that remind me of the dot-com and real estate bubbles of the past decade.  The popping of these two bubbles have caused so much pain, trauma and financial loss to so many tens of millions of people in the United States and throughout the world that the possibility of whether this is happening again with emerging economy ETFs cannot in good conscience be ignored.  The writing was on the wall while these two known bubbles were expanding, but conveniently ignored, often subconsciously and through complex rationalizations and self-deception.  Afterwards, however, when the damage was done, the main questions most people asked were, "What were we thinking? How did we let this happen?"

Are we in a deja vu situation? The possibility always exists.

I am troubled by the general lax financial analysis of emerging economy ETFs. Each of the ETF component companies can be overpriced, and collectively they can be overpriced when bundled, but I get the feeling that people are ignoring this - as long as the price is going up. As in the heady days of the dot-com bubble, mass psychology, as opposed to rigorous analysis, has taken the upper hand. The emerging economy narrative is taking precedence to the cold hard numbers of the component companies of the ETFs. 

It bothers me is that I don't see enough investors expressing concern about the real nuts and bolts aspects of investing - the tried and true fundamentals of value investing that Warren Buffett so effectively espouses.  I suspect that at some point in the future, financial historians of this era will conclude that a generation of investors, mesmerized by heady emerging economy ETF returns, simply took leave of their senses and stopped analyzing what they were buying. And with predictable results.

Anyone who lived through the dot-com meltdown a decade ago, or rigorously studied the causes of the Great Depression, has to always bear in mind that a great investment narrative can only take you so far, and for so long, in a share price.  When the Efficient Market Theorem priced dozens, even hundreds of dot-com related stocks in early 2000 at X, and within a period of months their share price had dropped by 80-99%, then one can only conclude that almost the entire global community of investors, during one roughly five year period in time, just as in the 1920s, were engaged in aggressive, self-rationalizing group think, and had taken leave of their independent analytical capabilities.  The pursuit of profits can definitely do that to an average person.  The question is - what percentage of people are average?  Why aren't there more Roubinis out there - the people with the moral and intellectual courage to stand up to the herd's conventional wisdom?

It bothers me is that many of the ETF providers do not provide reliable information on such basic information as PE ratios in their websites.  Instead, they mainly focus on ETF share price increase.  Yes, they all show the component companies of the ETFs, but the fact that so many of them do not include basic financial information, such as the weighted average PE of the ETF portfolio, even with regard to ETFs with over a billion dollars in them, sets off a flashing red light in my mind.  Perhaps many investors don't care about PEs and other financial statistics about the hundreds of underlying companies that they are investing in? Perhaps they are just speculating in a blind or semi-blind fashion?  So many of the ETF websites certainly encourage this! It's as if the SEC doesn't exist.  Where are the balance sheets, or anything approaching a meaningful balance sheet?  With emerging economy ETFs, we aren't investing exactly in parts of the S&P 500, or even the Russell 2000!  We are investing in hundreds of exotically named companies that we have often never heard of, in countries that we know almost nothing about!  Our ignorance is astounding!  While we may assume that many of these emerging economy countries are corrupt, do we know if this carries over to their corporate accounting standards?

While these emerging economy ETFs are being packaged by some pretty sophisticated and reputable Wall Street institutions, subject themselves to SEC regulation, many of the companies that they are packaging hail from far flung and exotic locales.  With management fees of as low as 0.20%, I assume that the American ETF "bundlers", sophisticated and law-abiding as they no doubtedly are, are doing essentially zero professional due diligence of the veracity and accuracy of the financial numbers that these emerging economy companies are presenting to be true.  If the financial industry was able to deceive and/or mess up with the sub-prime mortgages in the US, an entirely domestic matter, then they certainly can do the same with regard to start-up factories in rural BRIC and BRIC-like countries, factories that they have never seen, and CFOs that they have never looked in the eye, let alone conducted an independent audit of their accounting work. We are talking about dozens of emerging countries, dozens of foreign languages, dozens of legal regimes, and dozens of different levels of corruption.  I will let the reader's imagination take them wherever it does on the subject of potential corporate accounting fraud in such exotic third and fourth-world countries! 

In short, without international SEC-like legal standards, and compliance, as difficult as this is even in the United States, there should be no sound sleeping at night for investors who cannot afford to potentially lose their investments in emerging economy ETFs! Show me the person who really knows the level of integrity of the numbers that these companies are presenting. Show me the Securities law expert for large swathes of Asia, Africa, Eastern Europe and South America who can vouch for the true accuracy of combined PE numbers in ETFs that comprise a high percentage of the United Nations General Assembly!

As for why precious metals interest me more at this point than emerging economies, I will save for Part II!

Disclosure: vwo, ewx, frn, edc, emb, thd, tur, sil, gdx, gdxj, gld, dgp