Roadmap for Emerging-Markets ETFs

Paul Justice: Hi, there. I'm Paul Justice, director of North American ETF research at Morningstar.

I am here today to talk about emerging-market funds and the incredible growth that they have realized over the last several years. More people are choosing ETFs to gain their emerging-market exposure than they would, say, with their large-cap domestic equity exposure, even though those funds are much larger on a net asset basis.

On a percentage basis, emerging-market funds are extremely popular in the ETF space. 35% of the time, people are choosing an ETF to gain that exposure for a diversified emerging-market fund, and when they go into regional exposure, single country funds, that number grows to more than half the time that they will choose an ETF over a mutual fund.

Today to talk about this with me is Patty Oey, our emerging markets and foreign country ETF specialist.

Patty, thanks for joining me.

Patricia Oey: Thanks, Paul.

Justice: So there's been a ton of interest in emerging-market funds in general. Could you talk a little bit about the performance of emerging markets over the last several years and possibly why you think that's happening?

Oey: Well, in 2009, the emerging markets performed very strongly. They were up about 70%, and then last year they outperformed the S&P slightly, but so far this year in 2011, they are underperforming. They've spent most of the time in the red.

The main issue there is inflation. Inflation has picked up starting at the end of 2010, and a lot of developing-country central banks have begun a round of tightening, and this is expected to weigh on growth in the near term.

More recently, the political instability in the Middle East has also reduced investors' appetite for risk.

Justice: Now, when you're getting a diversified emerging-market fund--two of the four largest ETFs on the market today both follow the MSCI Emerging Markets Index: the Vanguard VWO, and the iShares EEM funds, with about $90 billion in assets each. You're getting exposure to a lot of different places. Could you talk about how many countries are represented by those and where some of the heavier weightings might be?

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Oey: Well, right now, the MSCI Emerging Markets Index has 21 countries in it. The largest weightings are China and Brazil. They're both about 17% of the Index. So when you're looking at these funds, it's definitely important to take a look at those countries because of their large weightings. So right now in China, the government is in the process of switching gears. They supported very strong 9% to 10% annual growth in GDP over the last decade, and right now, they have said that they are going to try to support growth that's slightly lower, but more sustainable going forward.

They've been very aggressive about tightening their monetary policy starting in early 2010 first to kind of dial back the stimulus from 2009, and then more recently to address inflation issues. But there are signs now that this tightening is maybe nearing the end, and that should be positive for Chinese stocks.

Brazil is also a big heavyweight in the index. They are seeing similar trends as well. The government is also looking to support slightly lower, but more sustainable growth rates, and they have also been very aggressive about tightening, in that it looks like it could be easing a bit in the future. But there's one risk I'd like to highlight in Brazil, the Brazil Index underperformed the Emerging Markets Index in 2010. The main reason for that is that it has Petrobras, which is a mega cap. It has a huge weighting in the Bovespa and the MSCI Brazil. They spent most of the year negotiating with the government. They want to extract oil from some deep sea reserves, and there are issues over how much they're going to pay the government for that, and there was a lot of uncertainty in the market, so that stock was down about 20% in 2010, and because it's such a big component of the index, it weighed on the market overall.

More recently this year, Vale, which is a mining company, they're also a mega-cap company, the government is looking to--actually I think this morning it said that they have pushed out the CEO because they felt that Vale was not investing enough in Brazil to kind of support the local economy. So they're probably going to replace him with someone who will invest more in Brazil to stimulate job growth. So that's a risk in the near term.

Justice: Interesting dichotomy, because if you're going to push out a CEO for not investing in Brazil, the Brazilian government already feels that foreign investors are investing too much there. They've put a 2% inflow tax on buying equities there.

Oey: Right.

Justice: So something that has been challenging for ETFs considering [how much exposure] the ETF space [has] to Brazil. If we aggregate all the ETFs and then look at the trading volume, the Brazilian holdings in U.S. ETFs actually would account for 40% of the daily volume on the Bovespa itself, which is just a fascinating figure to me.

So those are the two heavyweights, when we look at that exposure, but most of the headlines recently have been centered around Japan, and Japan itself is not an emerging-market country, but it is surrounded by emerging markets. Could you talk a little bit about some of the dynamics that are going on in that area?

Oey: Sure. Well, we see Korea being maybe a beneficiary. Korea is home to many world-class large-cap companies that compete with Japan in industries such as auto manufacturing and electronics and steelmaking, so they're probably well-positioned to step up and take market share in the short term.

Korean companies also received a vote of confidence last week. Warren Buffett was in town, and he was visiting companies. He is looking for investment opportunities, so that's a little positive there.

But on the flip side, Taiwan's index is very heavily weighted towards tech. It's about 60%. They could be facing headwinds due to the supply outages from Japan that would negatively impact a lot of the tech companies. We're also concerned that some of these tech companies that compete with Apple or supply parts to Apple competitors, they're facing uphill battle in the near term due to the runaway success of the iPad and the iPhone.

Justice: Well, these are truly intertwined economy, especially when you get into the tech sector. So I know with previous conversations with you, I think that you've got probably on the country-specific emerging market countries, you've got the most favorable outlook probably on Korea right now. Could you talk about ways to access that market and really what funds people should look at and what they should consider when looking at those?

Oey: Well, there are currently two South Korea ETFs. The first is iShares MSCI Korea, the ticker is EWY; and the second is IQ South Korea Small Cap, the ticker SKOR.

The first is a broad market. The second is a small-cap fund. We prefer the broad market, because it does have the big names such as Hyundai and Samsung Electronics, and steelmaker, POSCO. So that fund will be a good way to play that theme of Korean companies kind of taking market share from their [Japanese] rivals.

Justice: And those are the truly global leaders within the Korean economy, but if somebody is looking at the emerging consumer, the small-cap fund may be the way to go in that particular case.

Oey: Right.

Justice: Well, I appreciate the rundown on emerging markets. Thank you for joining us. For this and more ETF news, please visit our ETF center at morningstar.com or check out our ETFInvestor newsletter.