The latest trend in emerging-market exchange-traded funds is to leave out the biggest countries. But the focus should be on companies, not countries

SATURDAY, OCTOBER 5, 2013

New ETFs: Christening a Sinking Ship

By BEN LEVISOHN | MORE ARTICLES BY AUTHOR

The latest trend in emerging-market exchange-traded funds is to leave out the biggest countries. But the focus should be on companies, not countries.

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What was once a brilliant marketing concept has collapsed like a ton of bricks. That would be the BRICs, of course, the term for Brazil, Russia, India, and China coined by Goldman Sachs’ Jim O’Neill in 2001. Once a favorite of investors, it’s now so far out of favor that the latest trend seems to be excluding them from new emerging-market exchange-traded funds. But that ship has already sailed.Sure, the news has been bad. There was India’s rupee, which plunged as much as 20% this year, to its weakest level ever. Brazil is struggling to contain inflation amid anemic growth—with riots thrown in for good measure. Russia remains plagued with concerns about corporate governance and, well, its government. And can anyone forget the crescendo of reports about China’s looming credit crisis?

By the time companies come up with a new product, it’s usually near the peak.

Then there’s the performance. TheiShares MSCI Emerging MarketsETF (ticker: EEM), which has 40% of its portfolio in the BRICs, has dropped 9% in the past three years, trailing far behind theSPDR S&P 500 ETF’s (SPY) 47% gain. The iShares MSCI BRIC Index FundETF (BKF), meanwhile, has fallen 22%.

Against that backdrop, State Street Global Advisors filed to launch an emerging-market ETF, based on the MSCI EM Beyond BRIC Index, which has 15% in Taiwan, 15% in South Korea, and 12% in Mexico.

But excluding individual countries—especially big ones—is rarely a good idea. An investor who rushed out of the iShares MSCI EAFE Index ETF (EFA) after it dropped 19% from April 30 through Nov. 30, 2011, because of Europe’s credit woes, for instance, would have missed out on its 20% gain in the past 12 months. And remember when the S&P 500 spent the first decade of the 2000s trailing emerging markets? If you had bailed on it in 2010, you would have missed out on a nearly 50% return in the past three years.

As luck would have it, State Street’s filing came on Aug. 27, the very day that the MSCI Emerging Markets ETF bottomed out and began a rally that would lift it 9.1% through Sept. 30, besting the MSCI EM Beyond BRIC Index’s 6.7% gain. And among the best-performing developing nations during that period? The iShares MSCI Brazil CappedETF (EWZ), which gained 13%, and the iShares MSCI India Index ETF (INDA), which jumped 16%. In other words, the new ETF, when it is launched, is perfect for investors who prefer looking in the rear-view mirror. “By the time companies come up with a new product, it’s usually near the peak,” says Rick Ferri, founder of Troy, Mich.-based Portfolio Solutions.

A State Street spokeswoman declined to comment.

THE REAL PROBLEM, however, is one of size, rather than country. One of the reasons that the iShares MSCI Emerging Markets ETF performed so poorly during the past three years is that it owns big multinational companies. Smaller stocks, meanwhile, benefited from investor focus on the developing world’s growing middle class. But removing companies like China Mobile (CHL), Tencent Holdings (0700.Hong Kong), and Gazprom (GAZP.Russia) does little to solve that problem, as non-BRIC stocksSamsung Electronics (005930.Korea) and Taiwan Semiconductor Manufacturing (TSM) remain the two largest positions, while Mexico’s América Móvil (AMX) more than doubles its weighting from 1% to 2.5%.

The EGShares Beyond BRICs ETF (BBRC), which launched in August 2012, eliminates South Korea and Taiwan as well, to try to create a portfolio that is heavy on South Africa, Mexico, Malaysia, and Thailand. That doesn’t remove the large-cap bias, however, or eliminate big concentrated positions in South African companies likeNaspers (NPN.South Africa), MTN Group (MTN.South Africa) or Sasol (SSL), all of which make up more than 4% of the portfolio.

Investors would be better off adding small and midsize companies to their emerging-market holdings, says David Romhilt, head of manager research for the Americas at Barclays, rather than eliminating the BRICs. “There’s nothing wrong with the small companies in China, Brazil, Russia, or India,” Romhilt says. Two ways to do so: theDriehaus Emerging Markets Small Cap Growth fund (DRESX) and the SPDR S&P Emerging Markets Small Cap ETF (EWX). There’s even a long-short mutual fund to consider: the BlackRock Emerging Markets Long/Short Equity fund (BLSAX), up 0.7% this year, compared with the 8.1% drop in the iShares MSCI Emerging Markets ETF.

But don’t make the mistake of eliminating the BRICs completely. After the recent selloff and more recent rally, it’s unclear whether investors will favor big companies or return to their bet on the emerging-market consumer—and which countries will outperform. For that reason, most investors should own a broad-based emerging-markets fund—theVanguard FTSE Emerging Markets ETF (VWO) and the iShares Core MSCI Emerging Markets ETF (IEMG) are two cheap options—and wait for other opportunities to present themselves, says Sameer Samana, an international strategist at Wells Fargo.

“You don’t want the market to force your hand,” Samana says. “It’s a good time to stay broadly diversified.”

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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