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Best emerging markets ETFs

We pick out two ETFs that offer an easy way to tap into the attractive growth prospects of developing markets
September 25, 2012

Twenty years ago, you probably wouldn't have dreamt of investing in emerging markets as they were too risky. But the global financial crisis has challenged traditional concepts of 'safe' and 'risky'.

Advanced economies now have low yields, crippling debt and default concerns. By contrast, many emerging markets have started issuing bonds in their own currency, moving into a new virtuous circle of declining inflation and lower external borrowing needs.

The changing view of risk, coupled with some strong performance from emerging markets, has made them more popular among UK investors over the past 10 years. However, two years of relatively poor performance from emerging markets means that increased doubts about venturing into emerging markets equities are understandable.

Legal & General Investment Management's global equity strategist, Lars Kreckel, says: "It used to be nigh on impossible to find investors who didn't subscribe to a positive view about the prospects of emerging market economies and equities. But after two years of emerging market equities underperforming their developed market peers despite superior economic growth, it is not surprising that some scepticism has appeared."

Investors have been spooked by the volatility that goes along with investing in emerging markets. In 2011, political upheaval in Egypt led to a dramatic plunge in markets, culminating in the closure of the Cairo stock exchange - it later reopened.

Volatility is synonymous with risk. But with more risk comes the possibility of greater reward. And for an investor taking a longer-term view - typically 10 years or longer - the additional volatility of emerging markets can reap attractive returns.

Legal & General Investment Management argues that the long-term case for emerging markets equities remains very much intact. Growth prospects in emerging markets will continue to beat advanced economies in the future, and over the long term this should translate into superior equity returns. Furthermore, L&G forecasts that emerging markets growth will reaccelerate later this year, meaning past underperformance has created a buying opportunity for long-term investors.

One way to buy into this story is to buy UK large companies such as Unilever and GlaxoSmithKline that sell products in emerging markets.

However, investing in an emerging markets exchange traded fund (ETF) will give you more diversified access and will include smaller companies operating in these markets that are otherwise awkward to get. The downside here is that volatility in emerging markets is such that you will have exposure to poorly performing markets as well as outperforming markets in any particular year. But if you select an ETF that tracks an index that gives broad exposure to emerging markets over time, this should perform in your favour. Tracking a broad global index removes the need to make decisions such as 'should I invest in China this year'?

 

 

ETF options

db x-trackers MSCI Global Emerging Markets TRM Index ETF (ticker: XMEM) won Best Exchange Traded Product for Global Emerging Markets at our March 2012 fund awards. This tracks the MSCI Emerging Markets index, which consists of 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey. The index has 816 holdings across these countries.

What you have to watch out for in ETFs is the difference between physical and synthetic replication of the index. This ETF uses synthetic replication to track the index. It is a fully funded swap with a collateral basket. If you can't work out how this works, or are unsure about the counterparty risks entailed in this product, then you may prefer to invest in a physically-replicated ETF.

Here, we like iShares MSCI Global Emerging Markets (ticker: IEEM). This ETF tracks the MSCI Emerging Markets index by holding the underlying physical index securities. However, it does not invest in every stock in the index - instead it uses an optimised process, meaning the number of holdings are 522, compared with the index's 816. This may mean performance is slightly different to the index. Since inception on 18 November 2005, the ETF has returned 78.5 per cent to investors compared with 80.4 per cent from the index.

If you want to manage your asset allocation for emerging markets you could go for individual country ETFs. This could reap benefits if you get your selection right as the performance of individual markets varies enormously. For example, over the past year, performance among the Bric economies has seen Brazil deliver an 8 per cent gain compared with -18 per cent from China. You will have to monitor your allocation, reducing exposure when a market has risen substantially. iShares alone lists 10 ETFs that track individual emerging markets countries.

Alternatively, or in addition to emerging markets ETFs, you could buy an actively managed Global Emerging Markets fund. Visit our Top 100 Funds for our eight recommendations in this area: http://www.investorschronicle.co.uk/ICtop100funds