By
Morningstar
:
By Patricia Oey
Many investors are aware that
Vanguard MSCI Emerging Markets ETF (
VWO
)
and
iShares MSCI Emerging Markets Index (
EEM
)
(which both track the cap-weighted MSCI Emerging Markets Index) may
not be the best vehicles to gain access to the most attractive
growth trend in the emerging markets--a rapidly expanding middle
class and rising disposable incomes. For example, South Korean and
Taiwanese companies, which make up 15% and 11% of the MSCI Emerging
Markets Index, respectively, tend to be exporters with significant
exposure to North America and Europe. In China (18% of the index),
Brazil (14%), and Russia (6%), many of the largest companies tend
to be government-owned entities, which, at times, may have to put
political interests ahead of profitability. We also note that
Indian (6%) and Russian stocks tend to have low floats and not a
lot of domestic liquidity, so large foreign fund flows in and out
of these stocks further amplifies these markets' high
volatility.
Near-Term Concerns
The MSCI Emerging Markets Index is also exposed to a number of
current issues that concern us. About 20% of the index's China
exposure is in four state-run banks. In 2011, the performance of
these banks was weighed by concerns about the quality of their
balance sheets, as they were the largest lenders to support the
infrastructure stimulus spending in 2009. But a more significant
and longer-term headwind could be the government's plan to break up
what it calls "the monopoly of national banks" and allow for more
competition in an effort to address the underserved consumers and
small- and medium-business sectors.
Turning to Brazil, we find a market heavily weighted toward
material firms (21% of the index's Brazil exposure) and integrated
oil firm Petrobras (
PBR
) (16%). A slowdown in infrastructure and construction spending in
China, not to mention weak growth in the developed markets, will
likely weigh on mega-cap mining company Vale (
VALE
). Petrobras, as a state-owned firm, has to operate under
government-set gas prices (which hurts its refining business when
oil prices rise) and faces a number of execution risks in its
development of Brazil's vast deep-water reserves over the next
decade. For more details on Petrobras, please refer to my stock
analyst colleague Allen Good's article, "Petrobras' Tantalizing
Growth Comes With Baggage."
We are also concerned about the outlook for Indian stocks over
the next year or two. India, relative to other emerging markets,
has less leeway to stimulate its economy because of high government
deficits and inflation. We also note that, with national elections
scheduled for 2014, it will be difficult for the government to
enact necessary, but unpopular, reforms such as reducing food and
fuel subsidies. The government has also taken actions that have
negatively impacted foreign investor sentiment, like last year's
retreat to liberalize the retail sector and this year's talk about
retroactively targeting foreign investors for additional taxes.
Finally, we note that IT services, which accounts for 15% of the
index India exposure, is seeing a slowdown from its customers, most
of whom are from the developed markets.
Our Picks for Emerging-Markets Exposure
The most obvious way to gain access to the emerging markets' rising
middle class is to invest in funds that have a relatively high
exposure to consumer firms, which tend to be market-oriented,
entrepreneurial companies. Among exchange-traded funds, there are
only two funds we would recommend, so we have included two actively
managed mutual funds recommendations as well. All four of these
funds have exhibited lower volatility relative to the MSCI Emerging
Markets Index, which we think is an important criterion to consider
when investing in the emerging markets. Large-cap emerging-markets
consumer names also tend to pass through fundamental screens (such
as high returns, consistent earnings growth), which suggest they
are higher-quality companies.
EGShares Emerging Markets Consumer ETF (
ECON
)
invests in 30 large-cap emerging-markets consumer companies, many
of which dominate their respective markets. Given its concentrated
exposure to large, well-established firms, it's been less volatile
than the MSCI Emerging Markets Index. Top holdings include beer
producer AmBev (ABV), South African media company Naspers, and
Wal-Mart de Mexico. ECON has a heavier exposure to Latin America
(55% of the portfolio) and a lighter exposure to Asia (20%); its
top industry weights are beverages (16%), retailers (15%), and food
producers (14%). However, its 0.85% fee is high relative to other
emerging-markets ETFs. We also note that allegation of bribery at
Wal-Mart de Mexico (which accounts for about 6% of ECON) could
weigh on this stock in the near term.
WisdomTree Emerging Markets SmallCap Dividend ETF
(DGS)
is also a good option. While consumer firms comprise about 20% of
the fund, DGS has a 21% weighting in small-cap financials that
should benefit from growing demand for consumer banking services.
The financials sector also includes property developers, another
area tied to consumer spending growth. Although this is a small-cap
fund, it follows a dividend-weighted index (in the emerging
markets, dividends can be considered a proxy for quality), which
results in lower volatility relative to the MSCI Emerging Markets
Index. Its fee is 0.63%.
Justin Leverenz, portfolio manager of the popular
Oppenheimer Developing Markets Fund ((ODMAX))
, seeks out companies with significant and sustainable competitive
advantages that can generate high returns on capital throughout a
market cycle. As a result, his portfolio has a heavy 37% exposure
to consumer companies and a 17% weighting in tech companies that
are primarily well-established local Internet companies (most of
the IT companies in the MSCI Emerging Markets Index are part of the
global hardware supply chain). He avoids names that are trading at
high valuations and tends to keep portfolio turnover low. This
fund's expense ratio is 1.30%.
Thornburg Developing World Fund's ((THDAX))
manager Lewis Kaufman looks for three types of companies: (1)
established firms at attractive valuations, (2) those which have
exhibited steady earnings or dividend growth, and (3) companies
with emerging franchises. This fund may also invest about 20% of
its assets in developed-markets companies with significant
emerging-markets exposure, most of which is in U.S. companies such
as Colgate-Palmolive (CL). (The fund currently has a low 5%
exposure to companies domiciled in developed Europe, which face
more headline risk as the eurozone debt crisis continues to
simmer.) At this time, this fund has a very large 43% exposure to
consumer stocks. However, we think this fund is suitable for
more-risk-tolerant investors--it has a mid-cap tilt and a somewhat
concentrated portfolio of only 48 holdings. It also has a short
two-and-a-half-year operating history. Its fee is 1.62%.
Disclosure:
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Morningstar indexes.
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