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Emerging-market investors get a wake-up call

As old standby stocks fade, the brave will need to step directly into the pool with ETFs, DALE JACKSON reports

You don't have to go any further than the latest batch of third-quarter earnings to see how emerging countries are affecting the global economy.

Rival cellphone giants Motorola and Nokia both blamed a drop in profit on increased competition in emerging markets including India and China.

U.S.-based international telecom research firm Gartner Group estimates emerging markets will drive worldwide cellphone sales to $1-billion (U.S.) by 2009.

And it's safe to assume many of those cellphone conversations were business related. While economic growth hums at 4 per cent in Canada and less than 3 per cent in the United States, the Indian and Chinese economies are revving at rates of 9 per cent and 10 per cent, respectively.

It's nothing new that the developing world is developing faster than the developed world. The Morgan Stanley Capital International emerging markets index -- which includes equity markets in 26 emerging-market countries in Latin America, Asia, Africa, the Middle East and Eastern Europe -- has climbed 23 per cent annually for the past three years.

What is new is the increasing limitations on North American investors hoping to profit from that growth by investing in the old standby U.S.-listed multinationals such as Nokia and Motorola. Last week's $10-billion offer by India-based Tata Steel for Anglo-Dutch steel maker Corus brings to light the need for investors to get directly involved in emerging markets to reap the full benefits.

The most direct route to developing economies is through an emerging-market exchange traded fund (ETF). Naturally, emerging markets are riskier than developed economy markets, but emerging-market ETFs spread that risk through large, liquid stocks in several sectors on several exchanges.

Because they are unmanaged index funds, fees are much lower than those of actively managed funds, most less than 1 per cent. Investors will find two broad, emerging-market ETFs, both of which trade on the American Stock Exchange.

Barclays offers the iShares MSCI Emerging Markets ETF, which trades under the symbol EEM, and Vanguard offers the MSCI Select Emerging Markets Index as part of its Viper series under the symbol VWO. Holdings in the Barclays iShares ETF are weighted according to market capitalization, so the biggest stocks are South Korea's Samsung Electronics, Taiwan Semiconductor, Kookmin Bank of South Korea and South Korean steel maker Posco. Roughly 15 per cent of the holdings are banks, 15 per cent are in the energy sector and another 15 per cent are semiconductor related.

The Viper emerging markets ETF tracks a slightly different index administered exclusively for Vanguard -- the MSCI Select Emerging Markets Index. It includes 550 common stocks of companies that trade on emerging markets. The top holdings are similar to the Barclays ETF but weightings are different.

Returns so far this year have been fairly robust for both. Since Jan. 1, the iShares ETF has gained 15.4 per cent, while the Vanguard ETF has advanced 14.3 per cent.

It's important for Canadian investors to keep in mind that both ETFs are traded in U.S. dollars, which introduces a currency risk. The risk is even greater when you take into account additional fluctuations between the U.S. dollar and a specific country.

Other emerging market ETFs target specific countries or groups of countries including the so-called BRICs, which invest exclusively in Brazil, Russia, India and China. Claymore Investments Inc. became the first to list a BRIC on the Toronto Stock Exchange in September under the symbol CBQ. "Those four countries are the cornerstones of emerging markets right now," says Claymore president Som Seif. "For pure exposure to emerging markets, BRIC is the best thing."

Mr. Seif specifically points to Brazil and Russia's growing resource sectors, India's expanding information technology sector, and China's emerging consumer class. He sees all four economies expanding internally and as a trading block. "They've become less and less dependent on the U.S. economy and more dependent on their own."

Since its launch on Sept. 8, the Claymore BRIC exchange-traded fund has risen 7.3 per cent. Claymore expects to launch a broader emerging-market ETF in Canada to offer investors more diversity. "There's going to be people out there who believe the BRIC market is too focused," Mr. Seif says.

CIBC Securities offers an emerging-market ETF that is sold like a mutual fund on the Canadian market. The CIBC Emerging Markets Index fund tracks the MSCI Emerging Markets Index and includes a few emerging country-specific iShares. However, returns tend to be a bit lower mostly because of the 1.23-per-cent management expense ratio.

Despite a strong showing from emerging markets, a recent poll conducted by Merrill Lynch found that, for the first time in five years, global equity managers as a whole were underweight in emerging-market stocks. The reasons varied, but the fact that money managers are turning away from emerging-market equities highlights the biggest risk with ETFs: They don't provide the insight or foresight of an actively managed fund.

At least one international equity manager says the emerging-market blue-chips included in ETFs might be getting expensive. Don Reed, president and chief executive officer of Franklin Templeton Investments, says his bottom-up, value-investing method is drawing him toward small firms not included in emerging-market indices. "When you're investing in emerging markets there are a lot of good large companies, but there are also a lot of good small companies," he says.

In addition, good large-cap stocks in a weighted index fund are automatically sold when they fall out of favour, providing what Mr. Reed says is a discount for value investors like himself. He says he's been catching a lot of falling Taiwanese bank, telecom and tech stocks lately.

So far this year, Franklin Templeton's BRIC fund is the top performing emerging-markets equity fund, with a 26-per-cent return, handily outperforming the 16-per-cent year-to-date return for the benchmark MSCI Emerging Markets Index. The Franklin Templeton BRIC fund is about a year old, but over the past three years even the average emerging-markets equity fund has outperformed the MSCI emerging-markets index by nearly 2 per cent annually. Fidelity Latin America-B leads the three-year pack with a 37.2-per-cent average annual return.

Dale Jackson is a producer at Report on Business Television.

© 2007 The Globe and Mail. All rights reserved.

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