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By Patricia Oey | 09-18-2014 11:00 AM

Smithie: Emerging-Markets Indexes Have Let Investors Down

Emerging Global Advisors' Nick Smithie says standard indexes put too much weight on larger countries and sectors, with inadequate exposure to rising domestic demand.

Securities mentioned in this video
BBRC Columbia Beyond BRICs ETF

Patty Oey: Hi, we're here at the Morningstar ETF Conference. My name is Patty Oey, and I'm a senior analyst covering passive strategies on the manager research team.

I'm here today with Nick Smithie, the chief investment strategist at EG Global Shares. It's a company focused on emerging markets, primarily in ETFs.

Welcome. Thank you for joining us.

Nick Smithie: Thank you, Patty.

Oey: Emerging markets are starting to show signs of life this year after years of underperformance.

Smithie: Right.

Oey: What's changed?

Smithie: I think, Patty, we've had three or four years of stagnant earnings growth in emerging markets, which has really held back performance, both on a relative and an absolute basis. And after the interest rate increases last year and this year in response to the Fed's announcement about tapering, analysts brought down their growth estimates considerably. During the second half of this year, we've finally seen both companies and economies begin to improve beyond analysts' expectations.

So I think we have cyclical improvement in earnings growth in the second half of 2014 and again in 2015. I think that we have the option of reform in emerging markets, as we've seen with Mr. Modi's election, the Indonesian election, and the hopes of the voters in Brazil, perhaps, later this year. All countries are trying to change their governments to make more market-friendly macroeconomic policies.

Finally, I think that investors have realized that they've been running underweight positions in emerging markets for a long time, and they're beginning to close their significant underweights in the face of improving news from the emerging world.

Oey: We often talk about emerging markets as one big asset class, but in fact it's very heterogeneous. Are there countries or areas that you like, and maybe there are areas that you're concerned about?

Smithie: That's right, Patty. I think there is a tendency to consider emerging markets as a single homogeneous block; whereas, of course, it's not. And although the performance at the index level has been static for the last three or four years, what you've seen is a large dispersion of returns within countries within that universe, and the reason is that many countries have performed better than others.

At EGA, we think there are plenty of investment opportunities throughout emerging and frontier markets, but we don't particularly like the way in which standard indices have been constructed that give investors too great a concentration in large countries and sectors that have not been performing particularly well, and inadequate exposure in domestic-demand parts of emerging economies that have been doing extremely well indeed.

So we're always advocating the idea of emerging-market domestic growth and investors getting exposure to long-term superior domestic growth in emerging and frontier markets--not necessarily in the traditional weights that they would find with standard indices from better-known index providers.

Oey: You touched on frontier markets, and it has been a hot topic, as frontier markets have done really well over the last 18 months. Can you talk about how risky is this asset class? Do you have a product that provides exposure to frontier markets?

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