Investing in Emerging Markets with ETFs
Emerging Markets are a must for globally diversified investors. We explain how you can use ETFs to easily invest in fast-growing Emerging Markets economies – writes Jan Altmann.
Entry criteria for the Emerging Markets Club aren’t strictly defined but notable members include the BRICS (Brazil, Russia, India, China, South Africa), most of the MINTs (Mexico, Indonesia, Turkey) plus other big names from the Asian Tigers, the Gulf States, Eastern Europe and Latin America.
In other words, when you buy into the Emerging Markets, you’re buying into thousands of local firms with a large stake in some of the fastest growing and rapidly transforming countries in the world.
The speed of change can leave investor’s flat-footed: Emerging Markets now account for around 40% of global production.
And while the Developed World struggles with low growth and productivity puzzles, Emerging Markets are quickly catching up: aggregate economic growth was 4.7% in 2017-18 (IMF data – October 2018). Interestingly, Latin American and Eastern European economies expanded by a sedentary 2% – on par with developed countries. Whereas Asian countries leapt forward by 6.3%.
It’s change on that scale that makes the Emerging Markets vital for globally diversified investors.
Opening up Emerging Markets with ETFs
Emerging Markets ETFs enable you to diversify across all these countries and participate in their long-term growth by tracking a reputable index, like the MSCI Emerging Markets.
Naturally, performance tends to be more volatile in fast-developing countries, but you can reduce risk through the sheer diversity of an Emerging Markets index.
Low costs increase the prospect of returns, and you’re also spared the complexity of dealing with fluid regulatory regimes when it comes to items like foreign ownership and withholding taxes on dividends.
Each index provider divides the world differently. For example, MSCI counts South Korea as an Emerging Market whereas FTSE classifies it as Developed. MSCI categorises 24 countries as Emerging Markets, 23 as Developed, while remaining investible countries are labelled Frontier Markets.
There are ETFs that cover Frontier Markets too, and of course, big Frontier Markets like Vietnam are also covered by MSCI individual country indices.
Countries can be promoted and relegated. For example, MSCI demoted Argentina to Frontier Market status in 2009 but will bring it back up in 2019. Meanwhile, Saudi Arabia will enter the MSCI Emerging Markets for the first time this year.
Country influence upon an index can change too. The big mover here is the increasing weight of China in Emerging Market indices. That process is being driven by the liberalisation of China’s domestic stock exchanges, gradually allowing foreign investors (including ETFs) to own a wider range of Chinese firms.
The world according to MSCI
The three main Emerging Markets indexes tracked by ETFs are:
- MSCI Emerging Markets
- FTSE Emerging Markets
- MSCI Emerging Markets IMI
IMI stands for Investible Market Index which means it includes about 99% of each market’s free-float shares as opposed to the 85% targeted by the regular MSCI Emerging Markets index.
Emerging Markets indexes compared
Emerging Markets ETFs vs Developed Markets ETFs
Emerging Markets are generally characterised by higher volatility than Developed Markets. That’s the outcome of a riskier economic and political environment that’s susceptible to the effects of weaker institutions and regulation.
Many emerging economies are strongly dependent on exports and can be disproportionately affected by a demand crisis in developed countries. (Witness the vertiginous fall in Emerging Markets returns during 2008-09 in the graph below).
Crises can be exacerbated by US dollar movements (the primary currency of world trade) especially if large amounts of a country’s debt are held in dollars and the local currency falls.
You’re also exposed to currency risk on Emerging Markets holdings, and that can create an additional headwind for UK investors if the pound strengthens rapidly against local currencies.
As the graph shows, Emerging Markets have rocketed ahead at times, only to fall back to Earth later.
However, you’ll also notice the relatively low correlation in performance between the Emerging Markets and the MSCI World ETF that tracks developed countries. Low correlation can be a good source of long-term performance for your overall portfolio.
Performance: MSCI World vs Emerging Markets (04/03/2006 – 04/03/2019)
Cheap Emerging Markets ETFs
Emerging Market ETF costs have fallen sharply over the last decade and now start with OCFs of 0.18%. Competition between ETF providers means that Emerging Markets trackers are cheaper than single country products covering the same space – unlike with Developed World products. There’s also a range of physically optimised Emerging Markets ETFs available.
Of course, cost should not be your only selection criteria. The table below shows a strong level of competition between providers of MSCI Emerging Markets ETFs, so use our comparison tools to compare returns and choose a product that tightly tracks its index.
ETF portfolios: Emerging Markets asset allocation
Passive investors typically seek to hold equities in the same proportion as broad global market capitalisations and then adjust in line with their individual investment strategy.
Emerging Markets present a conundrum though because their investible stock markets only account for 11% of global capitalisation while their economies account for 40% of global production.
Hence there’s a strong case for upweighting your allocation in favour of the long-term growth opportunity. An asset allocation of 20% to Emerging Markets is reasonable. Some go higher still but bear in mind your tolerance of volatility if you want to allocate to Emerging Markets using share of world GDP.
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