Tapping emerging markets

PORTFOLIO POINT: Australian investors can access the strength of emerging markets through index funds and ETFs.

Emerging markets are set to outperform in the next phase of the recovery. Don’t believe me? Then ask Pimco’s Bill Gross, Templeton’s Mark Mobius, Fidelity’s Anthony Bolton or AMP Capital’s Shane Oliver (click here).

They’re all on record as saying that emerging markets will outpace developed economies. These opinions are supported by IMF forecasts for 2010, which predict GDP growth of just 1.3% for developed regions, 2% for Australia and 5.1% for emerging economies.

Given that these markets are known for their inherent volatility, the next question is just how much exposure should you have?

Sam Henderson, a senior adviser at financial planners Henderson Maxwell, says: “A conservative investor wouldn’t want to allocate any more than 5% at most, while an appropriate level of exposure for balanced investors would be somewhere between 5% and 10%. Growth-oriented investors should certainly be looking about the 10% mark.”

If that’s the case, how to get the best exposure to these runaway economies? You could pay an actively managed fund a hefty fee to underperform the index, which happens to three out of four international fund managers, according to Standard & Poor’s.

Alternatively, you could do what many other investors are doing and seek out the index funds and exchange traded funds (ETFs) that offer low-cost exposure to the economic powerhouses of tomorrow.

While the arguments for passive investing through index funds have been around for donkey’s years, ETFs remain a mystery to many investors. They shouldn’t. Most ETFs are simply funds designed to track an index that can be bought and sold on the ASX like any other listed security.

There are between 5000 and 6000 managed funds available to Australian investors, but the number dedicated to emerging market indices is small albeit growing. Barclay’s, State Street and Vanguard all provide ETFs but only Barclay’s suite of ETFs gives you access to the “new world”, while Vanguard also offers an index worthy of consideration. Investors comfortable with the passive approach to emerging markets may want to examine the following four options.

iShares FTSE/Xinhua China 25 (IZZ)

As the name suggests, this ETF mimics the return of the FTSE/Xinhua China 25, which tracks the 25 biggest Chinese companies open to international investors, including names you may already be familiar with such as China Mobile, Bank of China and Petrochina.

For investors who already hold Australian-listed companies that have considerable exposure to China, adding a purely China-based ETF to their portfolio may upset carefully constructed asset allocations, so consider carefully.

Conversely, if you want direct exposure to China’s financial services industry – which comprises 50.5% of the index – there’s no better place to go. But as you can see from the MER of 0.74%, it’s also the most expensive.

• In the six months to September 30 the FTSE/Xinhua China 25 returned 14% compared with the ASX 200, which returned 32.4%.

iShares MSCI BRIC (IBK)

This ETF is designed to mirror the returns delivered by the Morgan Stanley Capital International BRIC index, a weighted index of the biggest companies in the four emerging economies regarded as most likely to succeed: Brazil, Russia, India and China.

Its biggest holdings include energy giants such as Brazil’s Petrobras and Russia’s Gazprom. It also has large holdings in Reliance Industries, the $US100 billion Indian conglomerate, and Vale, Latin America’s answer to BHP Billiton.

Note that only 85.8% of its capital is directly invested into the countries that give the fund its name. Its fact sheet says 13.1% is invested through Hong Kong, which makes sense given that many Chinese companies are dual-listed. It also notes that 0.7% of its funds have been invested in the Cayman Islands, a region not normally associated with, shall we say, its rigorous compliance requirements.

• In the six months to September 30 the iShares MSCI BRIC ETF returned 31.6%.

iShares MSCI Emerging Markets (IEM)

Investors seeking a less narrow definition of an emerging market might prefer this fund, which invests in 22 countries. It includes major positions in Brazil, South Korea, Taiwan and China, and smaller positions in Mexico, Israel, Chile and Indonesia.

This fund is more inclusive, with 26% of its portfolio in IT and telco companies, including Samsung Taiwan Semiconductors, China Mobile and Chunghwa Telecom. It is also worth noting that of the three iShares ETFs, it has the smallest exposure to financials, at 24.9%.

After a review earlier this month, MSCI Global Standards added an additional 11 Brazilian companies and a further seven Chinese companies. With about $35 billion invested, this is the largest ETF on the market.

• In the six months to September 30 the MSCI Emerging Markets index returned 24.6%.

Vanguard Emerging Markets Index Fund

Much like the ETF from iShares with a similar name (above), this fund aims to match the returns of the MSCI Emerging Markets Index. The MER of the fund is lower than that of its ETF cousin, but investors must either buy it wholesale at a cost of $500,000 or through a wrap, which will carry higher administration costs.

Capitalised at just $430 million, it is a fraction the size of its rival ETF, which should mean that it is more susceptible to tracking error. This is what happens when funds cannot exactly replicate the index they represent, providing a greater or smaller return. But in an interesting twist, the fund actually tracked the index (which returned 28.05%) more closely than the iShares ETF.

• In the six months to September 30 the Vanguard Emerging Markets Index Fund returned 27.9%.

The availability of the MSCI Emerging Markets Index in both an ETF and an index fund begs the question of the relative advantages of each. The head of retail at Vanguard, Robin Bowerman, says: “No-entry-fee index funds mean that investors who employ a dollar cost averaging strategy with regular contributions aren’t going to pay brokerage every time they add to their holdings.”

Adam Seccombe, the co-head of Barclay’s iShares, describes the advantages of an ETF, saying: “If it’s important for you to trade on the exchange then ETFs are excellent vehicles where you have the flexibility of trading intraday, as opposed to end of day. You don’t have to wait for cheques to clear or New York to open to trade the S&P 500 '¦ you’re never out of the market for very long.”

Apart from the four vehicles mentioned, there are many other funds that have considerable exposure to the same markets such as the iShares MSCI Singapore Index; although Singapore is not an emerging economy, it has a burgeoning finance sector leveraged to China, the biggest emerging market of them all. In this basket you could also place iShares MSCI South Korea, iShares MSCI Hong Kong, iShares MSCI Taiwan and iShares S&P Asia 50.

That there is a somewhat limited choice of direct exposure to emerging market indices compared with the options available elsewhere in the financial services industry is not lost on Alex Dunnin, director of research at Rainmaker, which provides information on the funds management industry.

He says: “It’s a bizarre situation where you can see an adviser and get offered a combination of 27,000 different equity options and 15 million balanced funds but very little choice when it comes to investing directly in emerging market indices.”