There are countless ways to customize exposure to emerging markets, depending on the specific portfolio objective.
Though emerging markets stocks have lagged behind their U.S. counterparts over the last several years, many investors and advisors still recognize this asset class as a way to enhance overall return opportunities over the long run. Many asset class return assumptions still have emerging markets near the top, far ahead of other developed market stocks (though with greater volatility).
For investors who have made the decision to include meaningful emerging markets exposure in their portfolio, there are more decisions to make. As with all asset classes, exposure is not a binary decision; there are a number of different ways that an emerging markets position can be tweaked to deliver different risk and return profiles.
Perhaps the simplest way to slice up the universe of emerging markets stocks is along geographic lines. There are four primary regions of the world that host emerging markets, with numerous ETFs and mutual funds targeting each:
- Emerging Asia
- Latin America
- Emerging Europe
- Middle East and Africa
While these regions are part of the same larger asset class, they can be impacted by a number of different factors. Differing government structures and policies, natural resource wealth, and trade partners can lead to varying performances over both the short and long term.
Limiting emerging markets exposure to a specific region may make sense for those with a particularly strong point of view on the relative attractiveness of that region. But a more practical use will likely be used in addition to broad-based funds as part of a strategy to overweight a particular region expected to outperform.
BRIC Only Funds
Among the emerging economies that get the most attention from investors is the BRIC bloc of Brazil, Russia, India, and China. While these countries tend to be well represented in broad-based emerging markets funds, there are multiple products that target them exclusively:
- Guggenheim BRIC ETF (EEB)
- Templeton BRIC Fund (TABRX)
- Goldman Sachs BRIC Fund (GBRAX)
The BRIC acronym has become well-known over the past couple of decades, but the investment case for this specific group of economies remains murky. They were originally grouped together in 2001 by a Goldman Sachs economist who predicted that they would surpass the six largest western economies over the next 30 years. There were no defining common characteristics besides size and potential in 2001. At the time, the man who invented the term hadn’t even visited three of the countries.
Besides the sheer size of the economies, the BRIC components aren’t especially compelling or unattractive relative to the broader emerging markets asset class. The lack of any common geography, government structure, or key products or industries makes a BRIC-focused emerging markets strategy a bit random.
An opposite approach to emerging markets exposure involves overlooking the BRIC economies entirely, and instead focusing on smaller developing economies. Such a strategy could be used in a few ways: it could be the primary source of emerging markets exposure for those bearish on BRIC stocks for whatever reason, or could be used in a complementary role to achieve more complete exposure to this asset class.
There are a handful of ETFs and mutual funds available that can deliver exposure to the non-BRIC emerging markets:
- iShares MSCI Emerging Markets Horizon ETF (EMHZ)
- Global X Next Emerging & Frontier ETF (EMFM)
- SPDR MSCI EM Beyond BRIC (EMBB)
- EGShares Beyond BRICs ETF (BBRC)
- Goldman Sachs N-11 Equity (GSYAX)
Focusing on the non-BRIC emerging markets will generally increase the risk profile and return opportunities, as the emerging markets outside this group tend to be smaller and more volatile.
Frontier Markets Funds
Some of the funds highlighted above include exposure to frontier markets along with emerging economies. Frontier markets are smaller, less advanced economies that typically aren’t included in broad emerging markets funds. This development status brings with it some very significant risks — political instability and lack of market transparency can be common — but also significant long-term growth potential.
Frontier markets include countries like Argentina, Bulgaria, Kenya, Pakistan, Ukraine, and Vietnam:
Data Source: MSCI
Investing in single stocks from these countries isn’t a realistic strategy for most investors, so the funds that trade on U.S. exchanges will likely be better options:
- iShares MSCI Frontier 100 ETF (FM)
- Templeton Frontier Markets (TFMAX)
- HSBC Frontier Markets (HSFAX)
Frontier markets funds may be appropriate for investors who can tolerate short-term volatility if it means an opportunity to capture higher returns over a longer time horizon.
Small- and Mid-Cap Funds
When building out the U.S. equity component of a portfolio, investors will typically make allocations to large-, mid-, and small-cap stocks. Emerging markets exposure, on the other hand, tends to be achieve primarily through the largest companies in these markets. The table below shows the market capitalization breakdown of the largest emerging markets ETF and mutual fund: the Vanguard Emerging Markets ETF (VWO) and the Oppenheimer Developing Markets Fund (ODVYX):
Data Source: Morningstar
Adding in small- and mid-cap stocks can increase the long-term return potential (along with increasing overall volatility). These funds can make sense either as a higher volatility way to play emerging markets, or as a tool to round out the exposure offered by the more popular options.
Many ETFs and mutual funds that implement dividend stock strategies have seen huge inflows of assets in recent years, as investors have concluded that such an approach to domestic equities offers superior risk-adjusted returns. A very similar election can be made when it comes to emerging markets exposure; there are a number of funds that invest exclusively in emerging markets stocks that meet certain dividend consistency or dividend yield criteria.
- WisdomTree Emerging Markets Dividend Growth ETF (DGRE)
- BlackRock Emerging Markets Dividend Fund (BACHX)
- Voya Emerging Markets Equity Dividend Fund (IFCAX)
These funds could be used as alternative sources of emerging markets exposure for those who believe that dividend-paying stocks are a recipe for superior risk-adjusted returns over the long run.
Another strategy that has been popular with domestic stock allocations involves focusing on the stocks that have historically exhibited the lowest volatility. The PowerShares S&P 500 Low Volatility Portfolio (SPLV), for example, has gathered more than $5 billion in assets since its 2011 debut.
For those concerned with limiting drawdown potential, a low-volatility strategy can also be applied to emerging markets allocations through various mutual funds and ETFs:
- EGShares Low Volatility EM Dividend ETF (HILO)
- Invesco Low Volatility Emerging Markets (LVLAX)
- American Beacon Acadian Emerging Markets Managed Volatility (ACDAX)
These types of funds may be attractive to those who want to have emerging markets in their exposure, but prefer to limit the downside potential as much as possible. On the risk spectrum, this approach falls in between traditional emerging markets exposure and a cash position.
Currency Hedged Funds
Emerging markets are generally considered to be among the riskier asset classes. A big part of the volatility of these stocks relates to fluctuations in exchange rate. An investment in an Indian stock is not only a bet on the growth of that company, but also on the future of the Indian rupee.
Some investors may prefer to eliminate the uncertainty related to currency movements and essentially isolate the returns generated by emerging markets stocks. This can be accomplished through currency forward contracts, or more easily through one of the following ETFs:
- Deutsche X-trackers MSCI Emerging Markets Hedged Equity ETF (DBEM)
- iShares Currency Hedged MSCI Emerging Markets ETF (HEEM)
Currency hedging works both ways: if currencies such as the real and rupee appreciate rapidly relative to the dollar, hedged strategies will lag behind those that leave the currency exposure in place.
These funds would be appropriate for investors who want to eliminate the impact of movements in emerging currencies from their portfolios.
Even More Emerging Markets Strategies
There are several additional strategies accessible through mutual funds and ETFs for customizing emerging markets exposure.
- Ex-Taiwan, Ex-Korea: By many metrics, these Asian economies have graduated to developed status. Yet because they are still deemed to be emerging by many institutions, they can represent a large allocation in emerging markets funds. The shares Emerging Markets Core ETF (EMCR) is one of the products available with this geographic focus.
- Momentum: Just as a number of U.S.-focused funds build portfolios around stocks with positive momentum factors, there are similar products for the developing world. The PowerShares DWA Emerging Markets Momentum ETF (PIE) and AQR Emerging Momentum Fund (QEMLX) are two options here.
- Socially Responsible: Similarly, there are also funds that focus on companies in emerging markets deemed to be socially responsible. The DFA Emerging Markets Social Core Equity Fund (DFESX) executes such as strategy.
- High Beta: For those looking to take on as much risk as possible with this asset class, the strategy employed by the PowerShares S&P Emerging Markets High Beta ETF (EEHB) may have some appeal.
The optimal emerging markets fund will depend on an investor’s specific return objectives and his willingness to take on (or desire to limit) risk. Though there is a common theme that ties all of the funds highlighted above together, the differences in the management processes employed can result in very different outcomes.
About the Author: Michael Johnston
Michael Johnston is the Senior Analyst for All Emerging Markets, and also serves as the COO of parent company Poseidon Financial. His investment expertise has been featured in The Wall Street Journal, Barron’s, and USA Today, among other publications. He resides in Chicago.