How to use ETFs to build emerging market exposure

Julian Hince, senior business development officer for IFA sector at iShares Europe, says ETFs are ideal tools for investors to build exposure to emerging markets.

There is no doubt the global economy has experienced a severe and synchronised recession, and its effects are still being felt in numerous areas and sectors of the UK. At the same time, many investors are already looking ahead to what the financial system will look like after the credit crisis, and looking outwards and globally as to where they should be positioned to take advantage of opportunities for early and sustainable returns.

In previous global recoveries, the US has provided this locomotive for growth. However, as any expert will tell you, past performance is not necessarily a guide to future returns. This decade, countries such as China, India, Russia and Brazil have achieved higher growth rates than the US, Euro area and Japan as their economies have developed, production and exports increased and domestic demand expanded. According to World Bank figures, China’s GDP grew by 13% in 2007 and 9% in 2008, and India’s by 9% and 6.1% in those years, where the GDP average for OECD countries was 2.5% in 2007 and a lacklustre 0.6% in 2008.

Quest for economic leadership

The question many investors are facing today is where economic leadership will come from this time round, and how they should be positioned to take advantage of it. Emerging markets clearly demonstrate a strong potential for future growth. Consensus economic forecasts compiled by the World Bank suggest the GDP of developing markets are expected to grow by an average rate of 5.7% in 2011, in comparison with a rate of 2.5% for the US. In a recent poll, 43% of intermediaries believed emerging markets will outperform all other asset classes next year.

For those investors who want to gain exposure to the performance of emerging markets, Exchange Traded Funds (ETFs) can offer an effective, cost-efficient and transparent way to access the market or add additional weighting to the sector in their existing portfolios.

ETFs track the performance of specific-named indices. In the case of emerging markets, investors can opt for broad exposure through the MSCI Emerging Markets index, which includes more than 700 large and mid-cap stocks from more than 20 countries, or the FTSE BRIC 50, comprising the 50 largest companies by market capitalisation from Brazil, Russia, India and China that trade as Depositary Receipts or ‘H’ shares in the case of China.

Alternatively, investors can buy an ETF that accesses specific individual markets. In this instance, it is important investors research their products carefully, because the make-up of emerging market economies varies from one to the next. For example, an ETF based on the MSCI Brazil index will have a high weighting towards the commodity sector, because some of the largest companies in the country are energy and materials producers.

On the other hand, an ETF based on the MSCI Taiwan index will have a high weighting to the IT sector because of the relative strength of Taiwan’s manufacturing and export industry. Investors therefore need to take into account which sectors they believe offer the best prospects for growth, as well as which regions.

One of the key benefits of investing in emerging markets through ETFs is they are highly liquid instruments. ETF market-makers are responsible for ensuring liquidity, and ETFs are listed on exchanges, which means they can be traded at any time the exchange is open. It is often the case with emerging markets equities stocks are less heavily traded than their developed market counterparts.

This means investors buying equities directly can be exposed to a wide bid-offer spread, achieving a less effective price, and may find it difficult to execute transactions efficiently due to illiquidity. In addition, in markets such as India and China it can be challenging for foreign investors to buy certain domestic stocks because of local share ownership rules. In these instances, using ETFs can be more convenient than direct investment.

Beta for better exposure

ETFs offer beta exposure by tracking the performance of the index as a whole, and benefit from broad market growth. However, it is also possible to access emerging markets through active funds, looking for managers and funds that can outperform the market and generate additional returns.

Many investors will find emerging markets are currently under-represented in their portfolios, because during the credit crisis, investments were switched into lower risk and highly liquid products such as cash funds. In fact, our experience is the asset class is heavily under-utilised relative to developed equities.

For example, emerging markets represent almost 12% of the world equity market, which means to take a neutral position on the equity side of a portfolio, investors might consider a 12% allocation to emerging markets, and even more if they decide to take a stronger view on its performance prospects. Whether investors are taking a bullish view on emerging markets, or simply looking to dip their toe into the asset class, ETFs are ideal tools for building exposure in a time- and resource-efficient manner.