Emerging Market ETFs: More Acceleration Ahead?

Jonathan Bernstein, ETFzone.com Contributing Editor
July 17, 2010

Emerging market economies are growing much faster than developed economies. But assets held in emerging markets ETFs are not more expensive than in domestically focused funds. This is an opportunity for investors able to withstand the volatility endemic with emerging markets.The numbers tell the story. For 2010 the IMF estimates that the economy in China will grow 10.5%. India will grow at 9.4%, Brazil at 7.1%. These growth estimates stand out against a backdrop of 0%-3% for developed countries.Meanwhile the domestic benchmark Standard and Poors Depositary Receipts (NYSEArca:SPY - News), for example has a P/E (Price/Earnings) ratio of 15. The iShares MSCI Emerging Markets Index (NYSEArca:EEM - News), the largest emerging ETF by market capitalization also has a P/E ratio of 15.What accounts for this discrepancy? Investors may be balancing perceived risk of investing in emerging markets against the opportunity this growth provides.But investors are not standing still. Emerging market ETFs lead ETF growth. They are attracting record capital and now lead the ETF creation process. EEM now has a whopping 35 billion in assets. Vanguards Emerging Market ETF (NYSEArca:VWO - News) has about 20 billion.Investors are attracted to the returns. Emerging market ETFs have outperformed domestically focused funds for a decade. The chart below compares EEM with the SPY. As the chart shows, with the notable exception of the second and third quarter of 2008, EEM consistently outperformed the SPY over the five years shown in the chart. This outperformance survived many of the macro problems typically associated significant fluctuation in the value of the dollar and numerous rate change regimes. This suggests that investors pull money out of emerging markets only in the most extreme crisis moments for the global economy.To some extent this suggests a shift in overall investor sentiment toward emerging market businesses. Historically, investors have turned to emerging markets for higher returns and to lower portfolio volatility but have worried on their dependency on the West. Emerging market economies are doubly dependent on U.S. and Europe. First, the west provides a market for the emerging countries exports. When western economies struggle, emerging economies suffer a reduction in exports and have no domestic demand to substitute. Second, the West has historically provided capital. A downturn in the West is typically followed by reduced bank loans to emerging market countries and liquidity shocks. During a crisis, emerging market economies are unable to replace lost liquidity locally or through the IMF at a low cost. The result is that credit gets very expensive or dries up.Trouble in the West is unquestionably serious for emerging market countries. Declines in imports are felt immediately. But these economies are starting to grow their own internal demand and are not as susceptible as they were. They are blessed with demographic advantages and high growth rates. Perhaps most importantly, the developed economies are now mostly debtor nations, whereas emerging economies run surpluses and are flush with capital. Money flows, which traditionally moved from the developed economies to the emerging economies and increasingly moving in the reverse direction: from emerging economies to the West. This has increased emerging market countries independence and ability to deal with crisis without the cash of Western bankers. This independence may also help investors weather an anticipated asset devaluation when interest rates in western countries do finally rise in a few years.Emerging markets ETFs provide good and increasingly cheap exposure to these economies. One reason for VWOs strong growth despite its later introduction when compared with EEM is that it charges a slim 20 basis points in fees (0.20%). This compares with EEMs 0.72% expense ratio, still much cheaper than comparable mutual funds.One final point: emerging market ETFs are valued in the local currency. An important factors in their performance is the exchange rate against the dollar of the local currency in which those assets are dominated. A strong dollar will buy more foreign assets, so in periods of dollar strength emerging market funds tend to suffer. By contrast, dollar weakness is good for the performance of emerging markets ETFs, particularly if the funds holdings serve the domestic market and thus are more isolated from the potential for falling demand for a region's exports.The ETF family includes an impressive number of funds focused on emerging market economies. In addition to the broadly focused regional and super-regional emerging market ETFs like EEM and VWO, there are ETFs dedicated to specific countries, from South Africa to Malaysia to Chile. The list below includes some of the most influential and largest emerging markets ETFs and their expense ratios:GENERAL EMERGING MARKET ETFSiShares MSCI Emerging Markets Index Fund (NYSEArca:EEM - News), 0.72%Vanguard Emerging Markets ETF (NYSEArca:VWO - News), 0.20%SPDR S&P Emerging Markets ETF (NYSEArca:GMM - News), 0.59%BLDRS Emerging MKTS 50 ADR Index Fund (NasdaqGM:ADRE - News), 0.16%PowerShares FTSE RAFI Emerging Markets Portfolio (NYSEArca:PXH - News), 0.85%WisdomTree Emerging Markets High-Yielding Fund (NYSEArca:DEM - News), 0.63%BRIC ETFSstreetTRACKS SPDR S&P BRIC (Brazil, Russia, India, China) 40 ETF (NYSEArca:BIK - News), 0.48%Claymore/BNY BRIC (Brazil, Russia, India, China) ETF (NYSEArca:EEB - News), 0.60%iShares MSCI BRIC Index (NYSEArca:BKF - News), 0.72%REGIONAL ETFSSPDR S&P Emerging Middle East & Africa ETF (AMEX:GAF - News), 0.59%SPDR S&P Emerging Europe ETF (NYSEArca:GUR - News), 0.60%SPDR S&P Emerging Latin America ETF (NYSEArca:GML - News), 0.60%iShares S&P Latin America 40 Index Fund (NYSEArca:ILF - News), 0.50%FRONTIER ETFSVan Eck Market Vectors Africa Index ETF (NYSEArca:AFK - News), 0.83%Claymore/BNY Mellon Frontier Markets ETF (NYSEArca:FRN - News), 0.65%SPECIALTY EMERGING MARKETSPowerShares Emerging Markets Infrastructure (NYSEArca:PXR - News), 0.75%iShares S&P Emerging Mkts Infrastructure (EMIF), 0.75%PowerShares DWA Emerging Markets Technical Leaders (NYSEArca:PIE - News), 0.90%SPDR S&P Emerging Markets Small Cap (NYSEArca:EWX - News), 0.76%WisdomTree Emerging Makets Small Cap Dividend (NYSEArca:DGS - News), 0.63%WisdomTree Dreyfus Emerging Currency Fund (NYSEArca:CEW - News), 0.55%SHORT AND LEVERAGEProShares Short MSCI Emerging Markets ETF (NYSEArca:EUM - News), 0.95%ProShares UltraShort MSCI Emerging Markets ETF (NYSEArca:EEV - News), 0.95%Direxion Emerging Markets Bear 3X - Triple-Leveraged ETF (EDZ), 0.95%Direxion Emerging Markets Bull 3X - Triple-Leveraged ETF (EDC), 0.95%Jonathan Bernstein has been writing about ETFs since 2003 and is the author of Sector Trading: A Year in Exchange Traded Funds.