Get Direct Exposure to Emerging-Markets Consumers With This ETF

There is a lot to like about  EGShares Emerging Markets Consumer (ECON). This fund invests in 30 large-cap consumer services and consumer goods firms domiciled in the emerging markets (which in this case excludes Taiwan and South Korea). Many of these companies, such as Brazilian brewer and soft drink company  AmBev , Mexican convenience store operator and coke bottler  FEMSA (FMX) and Russian grocery chain Magnit are well-run, market-dominating companies with industry-leading profit margins. Given ECON's concentrated exposure to large, high-quality, well-established firms, this exchange-traded fund's underlying index has been less volatile than the benchmark MSCI Emerging Markets Index and has delivered significantly better risk-adjusted returns over the past five years. We think this fund is a solid option for exposure to emerging markets.

ECON's holdings are well positioned to benefit from strong growth in the consumption of food, clothing, entertainment, and leisure activities in the decades to come, thanks to rising income levels, urbanization, and a relatively young population in many emerging markets. At first glance, these firms’ shares appear very pricey. ECON is currently trading at 23 times trailing 12-month earnings, a significant premium to the MSCI EM Index’s 11 times trailing 12-month earnings. This can be partly attributable to strong investor demand for the firms in ECON’s portfolio, as there are relatively fewer consumer names in emerging markets—consumer companies account for about 17% of the MSCI EM Index, which is lower than their 23% weighting in the S&P 500 Index. We also note that while ECON’s P/E premium versus the MSCI EM Index has widened over the past three years, ECON’s P/E premium versus an index of global consumer firms and U.S. consumer firms has been relatively steady over the same time period, which suggests that ECON’s current valuations are not expensive relative to its global consumer peers (although consumer firms as a group are a little pricey, as they are trading at P/E multiples that are slightly higher than their 10-year average).

Trailing 12-Month Price/Earnings Ratios

--Source: Morningstar Direct, EGShares.

Recent currency volatility in the emerging markets has had an impact on the performance of this fund (but not on valuations, as P/E multiples are the same whether they are calculated using local currencies or calculated after share prices and earnings are converted into U.S. dollars). ECON has a relatively heavy exposure to South Africa, Brazil, India, and Indonesia--countries that have seen their currencies decline as much as 20% against the U.S. dollar in 2013. Like most foreign equity funds, ECON does not hedge its foreign currency exposure, so the performance of this fund is negatively affected when emerging-markets currencies fall in value relative to the U.S. dollar. With the U.S. delaying its plans to taper its bond-buying program and Japan maintaining its easy money policy in the medium term, we expect the currency headwinds from earlier this year to moderate in the near term. However, these four countries will continue to be susceptible to currency volatility given the fact that their current account deficits are partially financed by (more short-term-focused) foreign portfolio fund flows.

Since its inception three years ago, ECON’s portfolio has had very low turnover. However, following its annual rebalance last month, ECON’s weighting in Chinese companies rose to 16% from 6% due to a change in classification of Chinese p-chips (non-government-controlled Chinese companies listed in Hong Kong) from Hong Kong companies to Chinese companies. New additions include two narrow-moat companies-- Hengan International (01044) (a personal-care products company),  Belle International (a footwear manufacturer and sportswear retailer)--unrated Want Want China (a snack food company) and  China Mengniu Dairy (02319), a company that is continuing to focus on its supply chain after the tainted baby formula scandal in 2008. ECON’s larger China allocation came primarily at the expense of its India allocation, which fell to 7% from 10% after this year’s reconstitution. South African media firm (and ECON's largest holding at 10%) Naspers can also be considered a China play. It has a 34% stake in the China internet company  Tencent Holdings (00700), and this holding represents about 90% of Naspers’ market value. Naspers has actually benefited from a falling rand, as the value of its Tencent asset is based on the more stable Chinese renminbi. This tailwind for Naspers will moderate when the rand stabilizes.

While the long-term outlook is bright for the companies in this fund, there are near-term macro issues in ECON’s largest geographic exposures that investors should note. South Africa and Brazil are facing a period of slower growth after a decade of strong GDP growth on the back of a commodity boom and a significant consumer credit expansion. Consumer confidence in South Africa is currently very weak due to ongoing strikes in the mining and manufacturing industries. The health of the Chinese financial, property, and banking sector continues to be an overhang over the Chinese economy, and could impede the government’s ability to reorient the economy away from capital spending and toward domestic consumption.

ECON is our pick among the three consumer-focused emerging-markets ETFs. The first option, iShares MSCI Emerging Markets Consumer Discretionary , has a heavy 30% weighting in South Korean auto and consumer electronics companies—these firms serve the global marketplace and have a relatively lower exposure to the emerging-markets consumer. Also, EMDI, by design, invests only in consumer discretionary firms, whereas ECON has about a 50/50 exposure to consumer discretionary and consumer staple firms, making ECON a less volatile fund. The other option is WisdomTree Emerging Markets Consumer Growth Fund , which was launched last week. This fund is slightly different in that it has a 60% allocation in consumer firms and a 40% allocation in firms likely to benefit from consumer spending, primarily banks and telecoms. EMCG also screens for companies with relatively stronger earnings growth outlook, higher historical returns, and lower valuations. The fact that this fund employs numerous quantitative screens makes it difficult to predict how much the portfolio may change during its annual reconstitution. We recommend investors monitor EMCG’s live performance for at least a year before considering this fund.

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