ETF Basics: How to Invest in Emerging Markets

Posted on October 28, 2010 at 10:03 AM PDT by

All MarketRiders portfolios include exposure to emerging market stocks. We want to explain more about this asset class. Stocks in companies in the 20 or so nations included in the popular MSCI Emerging Markets index are dominated by Asia (predominantly Taiwan and Korea) at more than 50 percent, Latin America (20 percent), Africa and the Middle East (20 percent), and some smaller European countries. Investing in emerging market stocks is considered high-risk and high-return because you own companies in countries that are in an intermediate stage of development. Their economies are still developing and their stock markets are still gaining global clout.

Just because these countries like Brazil, India, Russia and China may be growing at record levels, stock prices don’t necessarily rise because their economies and governments are “emerging.” Shareholders benefit when companies grow after-tax profits. Governments of these countries might have onerous tax rates, state-sponsored price controls, securities laws that are not evolved or enforced, corruption, or risk of wars and violence, to mention a few common risks. All of these elements make these economies and their stock prices highly volatile.

Until a few years ago, the everyday investor had limited access to emerging markets, and when there was an alternative, he paid eight to 10 times more in fees than institutional and wealthy investors. Exchange-traded funds (ETFs) have truly democratized international investing. In the last six years, high-priced mutual funds averaging 1.5 percent in annual fees, like Morgan Stanley Emerging Markets (MGEMX), Lazard Emerging Markets (LZEMX), or T. Rowe Price Emerging Markets (PRMSX), have been challenged by superior, low-cost ETFs.

We recommend a single ETF for emerging market stocks: the Vanguard Emerging Markets ETF (symbol VWO). If you owned $10,000 of VWO, you would own a piece of 833 stocks in more than 20 countries and for only $27 per year (a 0.27 percent expense ratio). Vanguard trades, rebalances, and maintains this basket of stocks. You won’t have to figure out whether China will do better than Russia, or whether you should be investing in Mexico or Thailand. You won’t have to decide whether Petroleo Brasileiro is better than China Mobile or Samsung-or pay an arm and a leg to an investment pro to figure this out. With VWO, you’ll own them all.

If you want some of your emerging market allocation to include specific countries or even continents, there are more specific ETFs. For country and region ETFs, iShares offers, for example: EWZ (Brazil), FXI (China), EWY (South Korea), or even all of Latin America (ILF). Expenses for these ETFs range from 0.5 percent to 0.8 percent in fees and are the equivalent of buying the S&P 500 for these countries. Some of our members for example, may use VWO for 80 percent of their emerging markets allocation and then pick two countries and put 5 percent in each of these. They use the “I Want To Build It” path on the portfolio engine for doing this.

Investors who are new to ETF investing might have trouble making sense of out of all the hype and excitement. Don’t be fooled-most ETFs are irrelevant. In fact, many highly specialized ETFs are dangerous for most investors for a variety of reasons and appropriate for only the most active traders. Read the NY Times article below to better understand why.

Even with more than 1,000 available ETFs, just 80 of them account for 80 percent of all money invested in ETFs and the top 20 account for 50 percent of all capital invested in ETFs. Generally, stick with well-known, easy-to-understand products. For example, those that are composed of very liquid securities to avoid hidden trading costs that accompany some smaller funds.

Our members tend not to be active traders. We just want a common-sense, low-cost, globally diversified portfolio for retirement. For this purpose, there are only 20 or so ETFs that we use at MarketRiders to gain exposure to most asset classes.