Investors have been increasingly attracted to emerging market ETFs.
The possibility of a bubble in emerging markets has certainly been on lots of people's radar in the past four or five months. My own view is that emerging markets are potentially bubbly, and probably more so than developed ones, but not in a bubble right now.
Their potential to disappoint is greater because more investors are pinning their hopes on them, especially in the US. The table below shows how the leading US-quoted emerging market ETFs performed in the last eight months of 2009.
| ETF | Ticker | Assets
30 Apr 09 | Assets
31 Dec 09 | Growth in
assets | Price Rise |
|---|
| iShares MSCI EM | EEM (LSE:IEEM) | $25.8bn | $39.2bn | 52.2% | 46.8% |
| Vanguard EM ETF | VWO | $6.7bn | $19.5bn | 188.6% | 50.5% |
| iShares MSCI Brazil | EWZ (LSE: IBZL) | $6.1bn | $11.1bn | 83.0% | 30.4% |
| iShares FTSE/Xinhua | FXI (LSE:FXC) | $7.1bn | $10.2bn | 44.0% | 31.0% |
Emerging markets potential to disappoint is greater because more investors are pinning their hopes on them. There’s a stronger consensus that emerging markets are going to out-perform developed markets than there was before, especially in the US. The table below shows how the leading US-quoted emerging market ETFs performed in the last eight months of 2009.
The growing level of interest could, of itself, be a portent for a coming bubble. However, I suspect that the interest reflects a sea change in investor attitudes. I wouldn't be surprised if investor interest remains high even if these markets were to fall back significantly.
Bubble reality
That could be the wishful thinking of an emerging markets enthusiast, but I would also submit the following pointers for consideration:
- Investors are very nervy still; the trauma of September 2008-March 2009 has by no means entirely worn off. The recent stock market falls are evidence of a 'what can go wrong next?' mindset. And setbacks may not necessarily be due to bubbles; there may be more financial scandals yet to emerge.
- None of the emerging markets indices have yet managed to break through the peaks reached at various points between Autumn 2007 and the following May. In fact, that period looks like the real bubble in emerging markets.
- Our media consistently overemphasise the dependence of emerging markets on developed ones. For example, for us the China story is all about ill-will over the exchange rate and unfair competition, but even in 2007 China's exports to Europe and the USA only just outpaced exports to the rest of Asia. The real story is a long-term one about rising population, increasing numbers of consumers and growing trade between developing countries.
Those who believe that emerging markets are entering bubble territory might argue that, just as now, back in 2008 many were recommending riding the bubble but getting out in time. For most people, that's a fairly impossible task.
All of the four ETFs in the table have seen their prices decline this year and three of them have seen a greater decline in assets held, meaning investors have been net sellers. This could be a symptom of panic. However, this could also be because of a switch from the more expensive main iShares fund to the cheaper Vanguard one.
Taking precautions
Caution would be my watchword when choosing ETFs for emerging markets. A lot of the indices for individual emerging markets have drawbacks, such as being overly concentrated on a few very large companies or having an imbalance of industrial sectors represented.
Even the main iShares fund faces these issues, despite having 332 constituents and its largest holding, Samsung Electronics, accounting for just 2.68%. Overall though, it is rather heavily waited towards banks and energy/mining companies.
I'd rather invest in the newer and smaller iShares Emerging Markets Small Cap (LSE: IEMS), which is relatively much stronger in consumer products and industrials or iShares Far East ex-Japan Small Cap (LSE: ISFE).
Watch out for relatively high expense ratios -- db X-tracker Emerging Markets (LSE: XMEM) and Lyxor Emerging Markets (LSE: LEME) both have an expense ratio of 0.65%, but all the iShares ETFs mentioned are above 0.70%.
Also, remember that with emerging market ETFs, your real exchange rate exposure is to the currencies of the emerging markets themselves, rather than to the US dollar (if that happens to be the trading currency of the ETF).
My general strategy would be to have some emerging market ETF shares at all times but to rebalance some of my holdings into other assets if prices rise too far too fast.
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