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By Jeremy Glaser and Patricia Oey | 09-19-2014 02:00 PM

2 ETFs That Beat a Better Path to Emerging Markets

Morningstar's Patty Oey says these funds provide better exposure to emerging-markets growth than traditional market-cap weighted products.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We just wrapped up the 2014 ETF Conference. I'm here with Patty Oey; she is a senior analyst and manager of research. She led a few panels on emerging markets. We're going to talk about some of the big takeaways. Patty, thanks for joining me today.

Patricia Oey: Hi, thanks for having me.

Glaser: Let's start with the big-picture view of emerging markets before looking at some of the ETF specifics. What was the general sense about whether or not this is a good time to invest in emerging markets? How are people feeling about emerging-market equities right now?

Oey: Just to start off, it's very hard to make a general statement about emerging markets. They are a very heterogeneous lot. But uniformly, the portfolio managers and the speakers at our conference were sort of optimistic about Southeast Asia, India, and Mexico. These countries generally have good long-term growth fundamentals. They have young populations. And then many of these countries recently elected new leaders, and there is a lot of optimism that these leaders are going to institute reforms that will help unlock growth, such as instituting more market-friendly regulations and spending more money on much-needed infrastructure.

Glaser: Notably, you didn't mention China in that list. Were people a little bit more bearish on Chinese equities right now?

Oey: I think the issue is this: The Chinese government says that they are planning to grow about 7.5%, and we're not sure if they are going to hit it this year. So, the expectations are at a certain level. It's possible they are going to come under, and so that could be a headwind. But also, in general, a lot of the listed companies in China--a lot of these capital-intensive industries--they are operating at overcapacity. So, in terms of earnings growth and profitability, the fundamentals aren't very good.

Glaser: So, how big of an allocation should you have to emerging markets? Or should you have an allocation to emerging markets? Does it make sense for all investors? Some investors? Or is it just kind of a personal decision?

Oey: I think in most allocation models for the average investor, the allocation is probably about 5% within a 60-40 stock-bond portfolio. That's actually a very small allocation. For a long-term investor, very generally speaking, the growth fundamentals in emerging markets are there. And also, not every country is going to do well; but in general, you will see countries where the investor base will get stronger and institutional investors will become a more prominent player in the market. So, those are all good drivers for more liquidity and better capital markets.

Glaser: Let's take a look, then, at the vehicles you can use to invest in emerging markets. What's happening in the index space? Are we still seeing just those market-cap-weighted indexes, or has there been a proliferation of products there?

Oey: There have been a lot of new products. There is about a handful of really cheap market-cap-weighted funds. And generally, we're not so favorable on those funds, because what happens in the emerging markets is that a lot of the really big companies tend to be in industries that governments consider strategic industries such as banking and commodities, oil. And when you are in a strategic industry, government interference is not uncommon; so, we don't like those companies as much.

In terms of funds that we do like, we do like iShares Emerging Markets Minimum Volatility fund (EEMV). It tracks a rules-based index that seeks to create a portfolio that will be less volatile than the market-cap-weighted index. So, we like that fund. Another fund that we like is EGShares Emerging Markets Consumer (ECON). It holds a portfolio of really high-quality names. These names are brewers, packaged foods, retailers, media; a lot of these companies definitely are exposed to good growth drivers, and these are companies from about a dozen different emerging markets. Then, in the active space, we have Morningstar Analyst Ratings on about 20 funds.

Glaser: Patty, I certainly appreciate your take on emerging markets today.

Oey: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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