Investing in ETFs for Emerging Markets Growth

Emerging Markets (EM) are becoming increasingly essential for investors seeking global diversification in their portfolios. This article delves into how Exchange-Traded Funds (ETFs) facilitate investment in these burgeoning economies, highlighting their potential and the intricacies involved in investing in diversified markets.

Understanding Emerging Markets

While there are no rigid criteria for membership in the Emerging Markets club, notable constituents include the BRICS nations—Brazil, Russia (until its expulsion from the group in March 2022), India, China, and South Africa—along with MINT countries comprising Mexico, Indonesia, Nigeria, and Turkey. Other significant economies feature in this category as well, including several from the Asian Tigers, the Gulf States, Eastern Europe, and Latin America. Thus, investing in Emerging Markets allows exposure to a vast array of local firms capitalizing on the rapid development and transformation of some of the world’s fastest-growing economies.

ETFs: A Gateway to Emerging Markets

Emerging Markets ETFs offer an accessible way to diversify across these different countries and participate in their long-term growth by tracking established indices such as the MSCI Emerging Markets Index. The structure of ETFs provides inherent advantages, especially considering the often volatile performance commonly associated with fast-developing regions. However, the broad selection offered by ETFs means that risk can be mitigated through diversified holdings, simultaneously eliminating much of the complexity associated with investment regulations like foreign ownership and withholding taxes on dividends.

Classification Discrepancies among Index Providers

It is essential to refer to multiple index providers when evaluating Emerging Markets. For instance, while MSCI includes Poland and South Korea in its Emerging Markets classification, FTSE categorizes these nations as Developed Markets. MSCI currently classifies 24 countries as Emerging Markets, while 23 are designated as Developed, with additional nations categorized as Frontier Markets. For investors focusing on Frontier Markets, there are specific ETFs available that cover interactive markets with high-growth potential, like Vietnam, providing a nuanced layer of investment opportunities.

Track Record of Countries

Notably, countries can be moved between categories—MSCI demoted Argentina to Frontier Market status in 2009 but reclassified it back to Emerging Market status in May 2019. Conversely, Kuwait was introduced to the MSCI Emerging Markets Index for the first time in December 2020. The representation of various countries within an index can be influenced over time, with China being the most significant factor; its increasing weight in Emerging Market indices has been driven by domestic stock exchange liberalisation, allowing foreign investors—including ETFs—to hold a broader array of Chinese firms.

Key Emerging Markets Indices

The primary Emerging Markets indices tracked by ETFs include:

• MSCI Emerging Markets
• FTSE Emerging
• MSCI Emerging Markets IMI (Investable Market Index, which encompasses small-cap stocks and approximately 99% of each market’s free-float shares)

Comparison of Indices

Comparative Performance: Emerging vs Developed Markets

Emerging Markets are characterised by heightened volatility compared to Developed Markets, arising from riskier economic and political environments. Many EM economies heavily depend on exports, making them particularly vulnerable to downturns in demand from developed nations. These vulnerabilities can be further complicated by fluctuations in the US dollar, which serves as the global trading currency. If a country has significant debt denominated in dollars, a depreciation of its local currency may exacerbate economic turmoil.

Additionally, currency risk presents an added challenge. For instance, UK investors may experience headwinds if the British pound strengthens significantly against local currencies. The graph of historical performance between Emerging Markets and MSCI World ETFs illustrates the often divergent paths of these investments, wherein Emerging Markets may outperform during certain periods, only to falter later.

Cost Efficiency of Emerging Markets ETFs

The expense ratios associated with Emerging Markets ETFs have diminished significantly over the past decade, with some starting from an Ongoing Charges Figure (OCF) of just 0.14%. The fierce competition among ETF providers means that Emerging Markets trackers often come at lower prices than single-country products targeting the same sector, a trend not typically seen in Developed World ETFs. A diverse range of physically replicating Emerging Markets ETFs is now available, ensuring investors can choose from low-cost options.

However, investment costs should not be the sole focus when selecting an ETF. As evidenced in our analysis of MSCI Emerging Markets ETFs, highly competitive performance varies among providers, making it essential for investors to compare returns and opt for products that closely track their desired index.

Recommended Asset Allocation Strategies

Passive investors generally aim to hold equities that mirror broad global market capitalizations and adjust based on their investment strategy. In the case of Emerging Markets, a strategic allocation is somewhat contentious. Despite making up approximately 11% of global market capitalization, these markets account for about 40% of global production. Thus, there is a strong argument for increasing exposure to these markets, potentially justifying allocations as high as 40% to secure a foothold in long-term growth opportunities. Investors should consider their individual volatility tolerance when determining the right allocation aligned with world GDP.

Conclusion

Emerging Markets offer a promising avenue for diversification, albeit accompanied by distinct risks. Using ETFs to navigate these markets can significantly mitigate complexity and provide a structured approach to capitalizing on growth potential. With a range of investment strategies and indices available, investors must assess their options carefully to optimize their portfolios while remaining vigilant about the unique dynamics that characterize Emerging Markets.