Look for Consumer Sector Exposure When Selecting an Emerging-Markets Fund

Many investors are aware that  Vanguard MSCI Emerging Markets ETF (VWO) and  iShares MSCI Emerging Markets Index (EEM) (which both track the cap-weighted MSCI Emerging Markets Index) may not be the best vehicles to gain access to the most attractive growth trend in the emerging markets--a rapidly expanding middle class and rising disposable incomes. For example, South Korean and Taiwanese companies, which make up 15% and 11% of the MSCI Emerging Markets Index, respectively, tend to be exporters with significant exposure to North America and Europe. In China (18% of the index), Brazil (14%), and Russia (6%), many of the largest companies tend to be government-owned entities, which, at times, may have to put political interests ahead of profitability. We also note that Indian (6%) and Russian stocks tend to have low floats and not a lot of domestic liquidity, so large foreign fund flows in and out of these stocks further amplifies these markets' high volatility.

Near-Term Concerns
The MSCI Emerging Markets Index is also exposed to a number of current issues that concern us. About 20% of the index's China exposure is in four state-run banks. In 2011, the performance of these banks was weighed by concerns about the quality of their balance sheets, as they were the largest lenders to support the infrastructure stimulus spending in 2009. But a more significant and longer-term headwind could be the government's plan to break up what it calls "the monopoly of national banks" and allow for more competition in an effort to address the underserved consumers and small- and medium-business sectors.

Turning to Brazil, we find a market heavily weighted toward material firms (21% of the index's Brazil exposure) and integrated oil firm  Petrobras (PBR) (16%). A slowdown in infrastructure and construction spending in China, not to mention weak growth in the developed markets, will likely weigh on mega-cap mining company  Vale (VALE). Petrobras, as a state-owned firm, has to operate under government-set gas prices (which hurts its refining business when oil prices rise) and faces a number of execution risks in its development of Brazil's vast deep-water reserves over the next decade. For more details on Petrobras, please refer to my stock analyst colleague Allen Good's article, "Petrobras' Tantalizing Growth Comes With Baggage."

We are also concerned about the outlook for Indian stocks over the next year or two. India, relative to other emerging markets, has less leeway to stimulate its economy because of high government deficits and inflation. We also note that, with national elections scheduled for 2014, it will be difficult for the government to enact necessary, but unpopular, reforms such as reducing food and fuel subsidies. The government has also taken actions that have negatively impacted foreign investor sentiment, like last year's retreat to liberalize the retail sector and this year's talk about retroactively targeting foreign investors for additional taxes. Finally, we note that IT services, which accounts for 15% of the index India exposure, is seeing a slowdown from its customers, most of whom are from the developed markets.

Our Picks for Emerging-Markets Exposure
The most obvious way to gain access to the emerging markets' rising middle class is to invest in funds that have a relatively high exposure to consumer firms, which tend to be market-oriented, entrepreneurial companies. Among exchange-traded funds, there are only two funds we would recommend, so we have included two actively managed mutual funds recommendations as well. All four of these funds have exhibited lower volatility relative to the MSCI Emerging Markets Index, which we think is an important criterion to consider when investing in the emerging markets. Large-cap emerging-markets consumer names also tend to pass through fundamental screens (such as high returns, consistent earnings growth), which suggest they are higher-quality companies.

 EGShares Emerging Markets Consumer (ECON) invests in 30 large-cap emerging-markets consumer companies, many of which dominate their respective markets. Given its concentrated exposure to large, well-established firms, it's been less volatile than the MSCI Emerging Markets Index. Top holdings include beer producer  AmBev , South African media company Naspers, and Wal-Mart de Mexico. ECON has a heavier exposure to Latin America (55% of the portfolio) and a lighter exposure to Asia (20%); its top industry weights are beverages (16%), retailers (15%), and food producers (14%). However, its 0.85% fee is high relative to other emerging-markets ETFs. We also note that allegation of bribery at Wal-Mart de Mexico (which accounts for about 6% of ECON) could weigh on this stock in the near term.

 WisdomTree Emerging Markets SmallCap Dividend (DGS) is also a good option. While consumer firms comprise about 20% of the fund, DGS has a 21% weighting in small-cap financials that should benefit from growing demand for consumer banking services. The financials sector also includes property developers, another area tied to consumer spending growth. Although this is a small-cap fund, it follows a dividend-weighted index (in the emerging markets, dividends can be considered a proxy for quality), which results in lower volatility relative to the MSCI Emerging Markets Index. Its fee is 0.63%.

Justin Leverenz, portfolio manager of the popular  Oppenheimer Developing Markets (ODMAX), seeks out companies with significant and sustainable competitive advantages that can generate high returns on capital throughout a market cycle. As a result, his portfolio has a heavy 37% exposure to consumer companies and a 17% weighting in tech companies that are primarily well-established local Internet companies (most of the IT companies in the MSCI Emerging Markets Index are part of the global hardware supply chain). He avoids names that are trading at high valuations and tends to keep portfolio turnover low. This fund's expense ratio is 1.30%.

 Thornburg Developing World's (THDAX) manager Lewis Kaufman looks for three types of companies: (1) established firms at attractive valuations, (2) those which have exhibited steady earnings or dividend growth, and (3) companies with emerging franchises. This fund may also invest about 20% of its assets in developed-markets companies with significant emerging-markets exposure, most of which is in U.S. companies such as  Colgate-Palmolive (CL). (The fund currently has a low 5% exposure to companies domiciled in developed Europe, which face more headline risk as the eurozone debt crisis continues to simmer.) At this time, this fund has a very large 43% exposure to consumer stocks. However, we think this fund is suitable for more-risk-tolerant investors--it has a mid-cap tilt and a somewhat concentrated portfolio of only 48 holdings. It also has a short two-and-a-half-year operating history. Its fee is 1.62%.

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