Looking Beyond VWO And EEM

May 23, 2012

Broad-based, cap-weighted ETFs were the way to play emerging markets over the past decade. But it’s time for investors to become more strategic and look beyond VWO and EEM.

I moderated an emerging markets panel at our “Inside ETFs Europe” conference in Amsterdam, and that was the broad takeaway.

The panelists were mostly in agreement that other ETF options—such as country-specific emerging markets funds—are increasingly making more sense, as opposed to piling into the same broad, cap-weighted funds.

Currently, the Vanguard MSCI Emerging Markets ETF (NYSEArca: VWO) and the iShares MSCI Emerging Markets Index Fund (NYSEArca: EEM) are the third- and fourth-largest ETFs in the world, respectively. VWO has a staggering $54 billion in assets, while EEM has $33 billion.

But both ETFs track the same index, the MSCI Emerging Markets Index, which is a broad, cap-weighted index that is heavily weighted in China, Brazil, South Korea and Taiwan for a combined total of almost 60 percent of the portfolio.

The problem is that these countries have developed so much over the past few decades that it begs the question, How “emerging” are they and how fast will they continue to grow? And, crucially, do investors have the right expectations?

First off, Korea and Taiwan are almost in a class of their own compared with the other emerging markets.

Both countries have been developing rapidly for decades, and are close to achieving developed status. In fact, both FTSE and S&P have long upgraded South Korea to developed status in their respective index country classification systems.

The other problem with the MSCI Emerging Markets Index is its heavy weighting to China and Brazil. While the two countries have very different economic models for growth, Brazil is highly dependent on its exports of commodities to China. And Chinese growth is clearly slowing.

Whether China will continue its blistering growth or have a hard landing is hotly debated, but there might be another less-talked-about scenario. I recently read an excellent book by Ruchir Sharma, head of emerging markets at Morgan Stanley, titled “Breakout Nations.”

Sharma’s view is that while China’s growth may slow to around 6-7 percent, its economy is unlikely to crash the way some are predicting.

The problem is that while 6-7 percent growth is impressive by most standards, for a country like China that has had growth rates above 10 percent for years, it could feel like a recession. Also, China investors expecting double-digit growth rates may also be hit hard by slower growth.

 

But beyond China, Sharma has interesting views about different emerging markets in the coming decade.

He argues that the age of concerted and explosive growth together—the likes of which we saw in all emerging markets over the past decade—may be coming to an end. In place of that broad growth we’ve seen, the coming decade is likely to feature some markets that do better than others.

So where does Sharma see opportunities in emerging markets?

Interestingly, he is not so optimistic about the BRICs. Sharma seems more opportunity in countries like Poland, Czech Republic, Turkey, Indonesia and the Philippines, as well as in frontier markets like Sri Lanka.

He lists Poland and the Czech Republic as being in the “sweet spot” of Europe, referring to EU nations that are about to gain membership into the eurozone that have sound banking and financial institutions.

Investors have some options. There are currently two ETFs specifically targeting Poland: The $107 million iShares MSCI Poland Investable Market Index Fund (NYSEArca: EPOL) and the $29 million Market Vectors Poland ETF (NYSEArca: PLND).

There’s no Czech Republic-focused ETF yet, although Global X has put one into registration with the Securities and Exchange Commission.

Sharma, as I said, also likes Indonesia, Turkey, the Philippines and Sri Lanka, based on their fiscal health, favorable demographics and/or market-friendly political reforms now under way.

For those interested in Turkey, there’s the $369 million iShares MSCI Turkey Investable Market Index Fund (NYSEArca: TUR).

For Indonesia exposure, there are three options: The $270 million iShares Indonesia Investable Market Index Fund (NYSEArca: EIDO), the $483 million Market Vectors Indonesia Index ETF (NYSEArca: IDX) and the $4.7 million Market Vectors Indonesia Small-Cap Index ETF (NYSEArca: IDXJ).

For the Philippines, there’s the $136 million iShares MSCI Philippines Investable Market Index Fund (NYSEArca: EPHE), which has recently been on a tear despite the weakness in broad emerging markets ETFs. While there is no Sri Lanka ETF yet, Global X also filed to market a Sri Lanka ETF.

The takeaway here isn’t that investors should try to hit home runs by picking individual countries.

But after a decade of explosive emerging markets growth and in the post-financial crisis world, investors should increasingly do their homework.

They need to get a better understanding of the differences between the various emerging markets, rather than just blindly throw money in broad-based, cap-weighted funds like VWO and EEM.

 

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