Investing In Emerging Markets ETFs

According to FTSE’s research paper, emerging market economies are being driven into the forefront of global economic growth due to the emergence of new middle class, rapid urbanization, move from export-led to consumption-led growth, and emphasis on production of higher value products.

The Organisation for Economic Co-operation and Development (OECD) is projecting China’s share of the world GDP will rise from 11% in 2011 to 28% by 2030.  India’s share will go from 7% in 2011 to 11% by 2030.  USA’s share of the world GDP is projected to shrink from 23% to 18% over the same period.  Canada’s share will shrink from 2% to 1.6%.  As a result, it probably makes some sense for long term investors to allocate a portion of the portfolio to the emerging countries.

Source: OECD

Share of Global GDP – 2011 (Source: OECD)

Source: OECD

Share of Global GDP – 2030. (Source: OECD)

There are several ETFs available that can be used to invest in the emerging markets.  Below are 2 equity ETFs and 2 bond ETFs that can be used to invest in the emerging markets.

Equity ETFs

Vanguard’s Emerging Market Index ETF (VEE)

This ETF tracks the performance of the FTSE Emerging Markets index which is a market capitalization-weighted index, which basically means larger companies in the index (and consequently, the ETF) will carry more weight in terms of representation and returns.

One main reason to consider this ETF is that it is the cheapest emerging market ETF available in Canada with a management fee of 0.49%.  Of note, this ETF will slowly reduce exposure to South Korea as it is now classified as a ‘developed market’ by FTSE.

iShares Broad Emerging Markets Index (CWO)

This ETF tracks the FTSE RAFI Emerging Markets index.  This index uses 4 fundamental factors to determine a company’s weight in the index according to specific rules.  These factors are dividends, cash flow, sales, and book value of a company.

This ETF is more expensive with a management fee of 0.65%, but since it uses a different indexing methodology, I prefer to use this ETF to get style diversification.

Bond ETFs

There are several options to access emerging market debt investments including forward-currency contracts, local currency sovereign bonds, USD-denominated sovereign bonds and USD-denominated bonds of EM corporations.

The 2 ETFs discussed below are both sovereign (government) bonds.

BMO Emerging Markets Bond Hedged to CAD Index ETF (ZEF)

This ETF tracks the Barclays Capital Emerging Markets Tradable USD Sovereign Bond Index CAD Hedged benchmark (now that’s a mouthful).  The bonds held are U.S. dollar denominated sovereign debt from emerging market issuers, and the currency is hedged back to Canadian dollars.

According to the Exploring Emerging Markets Debt article in the Journal of Indexes, most of the emerging market USD sovereign bond yields are influenced by the changes in the U.S. Treasury curve more than the local emerging market factors.

SPDR® Barclays Emerging Markets Local Bond ETF (EBND)

This ETF tracks the Barclays EM Local Currency Government Diversified Index which is a fixed-rate local currency sovereign debt of emerging market countries.  Investors benefit from diversification through gaining exposure to local economic and interest rate factors.  This ETF trades in the U.S. so Canadian investors will be exposed to an additional USD-CAD currency risk.

About Emerging Markets Index Benchmarks

Not all emerging market indices are created equal, and since ETFs track various benchmarks, it is a good practice to check what the underlying index of an ETF holds.

For instance, according to Standard and Poor’s article Looking Beyond Traditional Benchmarks To Add Value In Emerging Markets, traditional market capitalization weighted emerging market indices like the MSCI Emerging Market Index have a heavier concentration to the more mature economies like South Korea.  In addition, the index is also lacks exposure to smaller companies which can often show higher growth.

The U.S. has more ETFs to choose from to invest in the emerging markets if you want to be more tactical and diversify away from the traditional market capitalization index.  Some of these ETFs are shown in Exhibit 11 of the article mentioned above.

 

REFERENCES

1. Emerging Markets: Crossing the Rubicon

2. FTSE RAFI Emerging Index Fact Sheet

3. OECD – Looking to 2060: Long-term growth prospects for the world

4. S&P Dow Jones Indices- Looking Beyond Traditional Benchmarks To Add Value In Emerging Markets

5. Journal Of Indexes: Jan/Feb 2013 – Exploring Emerging Market Debt

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