When Are Emerging Markets Not Emerging Anymore?

March 17, 2010

Emerging markets are all the rage these days, and knowing which ETF is best is partly about realizing that all indexes are not created equal.

With emerging markets all the rage these days, the question of what constitutes an emerging market is becoming more important. Billions of dollars are riding on the answer as different ETF providers slice and dice the space differently, creating different ETFs with different returns.

Two leading emerging market ETFs—Vanguard’s VWO and EEM from iShares—are both based on the MSCI Emerging Markets Index, which for now includes Israel, Korea and Taiwan. However, Emerging Global Advisors, a New York-based newcomer to the ETF market, has decided to base its broad emerging market exchange-traded fund, EEG, on a Dow Jones index that doesn’t include the three countries.

Performance data on the Dow Jones Emerging Markets Titans Composite Index and the MSCI Emerging Markets Index are broadly similar, though the Dow Jones Titans Index has tended to rise and fall a bit more sharply than the MSCI index. Korea and Taiwan will remain part of MSCI’s Emerging Market Index at least until mid-2011, though
Israel will drop off in late spring, MSCI Barra said.

“We worked in consultation with the client and they wanted a more pure representation of emerging markets,” Richard Ciuba, senior director of business development and sales at Dow Jones Indexes, said in a telephone interview about Emerging Global. “If you included Korea and
, you would have seen they would have dominated those indexes, and really not given the client the total representation they were going for.”

How much a given country dominates an index matters less to MSCI Barra, which instead looks at how easy or difficult it is for foreign investors to gain access to a given market before it makes a decision about a given country’s classification, according to Frank Nielsen, executive director and head of applied and index research at MSCI Barra.

A competing exchange-traded fund, State Street Global Advisors’ SPDR S&P Emerging Markets ETF (NYSEArca: GMM), uses a benchmark that excludes Korea, but includes Taiwan and
. The SSgA fund is built on the S&P Emerging BMI Index, which categorizes
as a developed market.


MSCI Vs. Titans Vs. S&P Performance

MSCI Vs. Titans Vs. S&P Performance

Already Emerged?

The three countries—not least Korea, now one of the world’s top high-end manufacturers—don’t fit the emerging market profile anymore, according to Richard Kang, chief investment officer at Emerging Global. They all have per capita gross domestic product of more than $20,000 a year and have established middle classes, disqualifying them from the International Monetary Fund’s definition of an emerging market.

“You go there—to Incheon Airport in Seoul, or you go to Taipei or Tel Aviv and look at their airports, and it’s La Guardia [in New York] that looks like the third world, it really does,” said Kang in a telephone interview. “Everything looks and feels like a developed economy,” he said, referring to the three countries. They all have vibrant health care and technology industries and few poor people, unlike most emerging market countries that rely on natural resource exports and are often teeming with poverty.

When counted as emerging markets in an index, the three countries make up big percentages of any index fund, potentially playing an outsized role in any portfolio that’s designed to take full advantage of the high growth rates that emerging markets offer investors.


South Korean companies make up the third-biggest country holding for Vanguard’s VWO, at 12.1 percent; Taiwan is No. 4 with 11.4 percent and
Israel is ninth with 4.0 percent. Korea is EEM’s second-biggest country holding, at 12.3 percent; Taiwan is fourth, at 10.5 percent and
is tenth, at 3.4 percent.

Both ETFs were among the 10 biggest U.S. ETFs by size at the end of February, according to data from the National Stock Exchange. EEM, the oldest among competing emerging market ETFs, was third-biggest, at $33.40 billion, compared with $20.10 billion for VWO, which was seventh-largest. Emerging Global’s EEG, which launched in July 2009, has gathered about $29.1 million in assets. SSgA’s GMM has attracted about $134 million since its rollout almost three years ago.

San Francisco-based iShares’ EMM has 476 holdings, compared with more than 800 for VWO, the result of so-called optimization by the iShares fund aimed at achieving investment exposure similar to the index, but with a fraction of the positions. Emerging Global’s EEG currently focuses on the largest companies and has 83 positions. It has a net expense ratio of 0.75  percent compared with 0.72 percent for EEM and 0.27 percent for VWO.

Investors’ Opinions Matter

As it reviewed Israel, Korea and
last year, MSCI Barra talked to investors to solicit their opinions on whether they considered these countries to be as investable as some of the weaker developed markets.

Israel elicited no concerns apart from short settlement cycles on the Tel Aviv Stock Exchange, while Korea and
failed to pass muster as developed markets for MSCI Barra.

“Therefore it was straightforward at that point to announce
’s transition into a developed market,” Nielsen said in a telephone interview.

“It’s more administratively difficult for foreign investors to work within the Korean or
markets,” he added. Nielsen stressed that in both countries, the lack of offshore currency markets as well as difficulties in setting up so-called omnibus accounts for fund companies to centralize all their bookkeeping were major drawbacks. “At the same time, these markets over the past couple of years have made major progress.”

MSCI Barra gives investors and fund companies a year to digest any status-change decisions. It announced the decision on Israel last year, and any status changes to Korea or
won’t be announced until June of this year, Nielsen said. He declined to speculate about the outcome of MSCI Barra’s reviews on Korea and

“It’s all about the investability and accessibility from a foreign investor's perspective.”


Volatility: MSCI Vs. Titans Vs. S&P Emerging BMI

MSCI Vs. Titans Vs. S&P Emerging BMI


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