The Case for Emerging Markets ETFs
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
With concerns about what could happen to the global economy and the possibility of a financial crisis in Europe, emerging markets underperformed U.S. markets in 2011. In that context many preferred the safety of well-known U.S. assets, both bonds and stocks. However, things may be starting to change.
Emerging markets have been going strong in the last month, and that trend could certainly continue if economic fundamentals keep moving in their recent direction. Europe seems to be more stable recently. Nobody knows how long this stability will last, but for the time being it bodes well for risk takings and emerging markets.
The Federal Reserve has announced that interest rates in the U.S. are going to continue at record lows until 2014 -- that is bearish for the dollar and bullish for commodities. What's bullish for commodities is usually bullish for emerging markets, since they are big exporters of natural resources. Monetary policies in the U.S. can have important implications in emerging market countries for a long time.
If things turn for the worse in the economic scenario, emerging markets will probably fall harder than their U.S. counterparts, but there are still good reasons to invest in these countries from a long-term perspective. Emerging countries have better growth prospects and lower levels of national debt and fiscal deficits than the U.S., Europe or Japan. In the long term these markets have a good chance of over-performing developed ones, so any weakness can be considered a chance to increase positions at low entry prices.
iShares MSCI Emerging Markets Index (NYSEMKT: EEM) is the most popular emerging markets ETF. It follows the performance of the MSCI Emerging Markets Index, which is a well-diversified index of emerging market stocks. To get an idea about valuations, Morningstar reports that the forward P/E ratio of this index is at 9.7, which shows that emerging market stocks are trading at very reasonable valuations.
Despites EEM's popularity, a more attractive alternative is Vanguard Emerging Markets (NYSEMKT: VWO), which tracks the same index but does it with lower expenses. This ETF has an expense ratio of 0.22%, which is considerably lower than the 0.67% expense ratio that the Ishares product has.
VWO has lower liquidity than EEM, but it's still quite a liquid product -- it had an average daily volume of more than 20 million shares in the last three months. Looks like VWO's cost advantage is better than EEM's liquidity advantage for most investors, and is probably the best ETF for investing large-cap emerging market stocks.
Targeting specific themes between emerging markets can also be a very interesting idea. Many investors like to focus on the BRIC countries, which are believed to have the most explosive growth prospects among the group. In that case you may want to consider the IShares MSCI BRIC (NYSEMKT: BKF), which invests in a basket of more than 300 companies representative of Brazil, Russia, India and China. After all, if these countries are going to become the next economic powers, it could be smart to buy a group of cheap stocks and hold them for the long term.
Another idea worth considering is to look for dividend stocks in emerging countries. Dividends add safety and income, and they help avoid the most speculative stocks. Of course, you can lose some high-growth names when you enter the dividend space, but I believe these ETFs offer a convenient risk and reward equation. WisdomTree Emerging Markets High Yield (NYSEMKT: DEM) pays a 4.5% dividend yield by investing in emerging market stocks with the highest dividends.
An even better alternative could be WisdomTree Emerging Mkts Small Cap Dividends (NYSEMKT: DGS), which focuses in smaller companies with high dividend yields. Smaller companies have better growth possibilities than bigger ones, and they can also show a better exposure to the growing middle class in many emerging markets. This ETF pays a dividend yield around 4.1%.
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