Emerging markets are a heterogeneous grouping of countries with evolving economies, so a broad basket index tracker may be a good fit. Helaine Kang suggests ETF picks.
Against the backdrop of lofty valuations for many developed equity markets – the US in particular – the investment proposition of emerging markets has been gaining traction recently. Whether as a satellite holding to increase geographical diversification or as a core element driving an investment portfolio’s growth, the rationale for investing in emerging markets remains solid: to benefit from these countries’ higher economic growth potential.
However, investing in emerging markets can be tricky, due to their highly dynamic nature. Thanks to dramatic changes in economic fundamentals and financial market developments, the group of countries regarded as ‘emerging markets’ has evolved over time. This is demonstrated by the change in country constituents and their weightings in global equity market indices over the past three decades. In 1988, emerging markets comprised only 10 countries and represented 1% of the MSCI All Country World index. By the end of 2018, the number of countries had increased to 24 and their combined weight was 11%.
Emerging markets are a growing but heterogeneous country universe; thus, one can find merit in investing selectively in certain countries. This can be done with exchange traded funds (ETFs). However, this ultimately has to do with market timing and thorough ongoing research, which is a rather tough task for most investors. Besides, one should also consider unique currency risks when making single-country plays, as well as the additional costs of buying a selection of individual country ETFs or active funds that are country specialists.
We view investment in a single fund tracking a basket of emerging markets as easier, cheaper and less risky. Broad-basket emerging market ETFs provide general diversification while allowing investors to ride the structural changes of emerging markets. Importantly, broad emerging market ETFs tend to charge lower fees than their individual emerging economy counterparts.
There is a wide range of broad emerging market ETFs tracking different indices, and it is worth paying attention to the differences among these indices.
Index approaches: know your benchmark
The emerging market benchmarks most commonly tracked by ETFs are those offered by MSCI and FTSE. While the fundamental construction rules of these two are largely the same – that is, they are market-cap weighted and cover large- and mid-cap stocks – the biggest variance lies in their approach to country classification. MSCI considers South Korea as an emerging market with a weighting of 13-15%, while FTSE regards it as a developed country and therefore excludes it.
Although this could lead to a slightly higher technology sector weight for MSCI, such differences should be negligible over the long term. Both FTSE and MSCI are representative of the broader emerging markets, with a large number of constituents: over 800 for MSCI and 1,000 for FTSE.
One important consideration to keep in mind with these market-cap weighted indices is concentration risk at sector or country levels at a given time. China and Taiwan currently represent over 30% and 11%, respectively, of both the MSCI and the FTSE emerging market indices. Both indices skew heavily towards the financial and technology sectors, which each represent 20-25% of the total portfolio.
However, indices are not static investment propositions. They will continue evolving according to the economic and financial market development of the underlying countries. Twenty years ago the biggest countries represented in the MSCI EM index were Brazil and Mexico, with a combined 23% weighting. Fast forward to 2019 and the weighting of these two countries has shrunk to around 10%, while Asia dominates with China, South Korea and Taiwan exceeding 55% of the index – more than doubling from their previous share of 21%. The chart shows how the relative weightings of Brazil and China have shifted over that time.
Key country weightings in MSCI EM Index
Source: Morningstar, as at 31 March 2019
ETF picks for access to broad emerging markets
Despite the above-mentioned concentration risks, funds that track these standard market-cap weighted indices have generally beaten the Morningstar emerging market category average over the long term.
Investors can gain access to broad emerging markets at a relatively low cost. For example, UBS ETF MSCI Emerging Markets, iShares core MSCI EM IMI ETF, Amundi ETF MSCI Emerging Markets and Vanguard FTSE Emerging Markets ETF charge between 0.18% and 0.27%. UBS and iShares have also earned a Morningstar Analyst Rating of Bronze.
Helaine Kang is an analyst, passive strategies, at Morningstar.