If you’re like many investors these days, you’ve made a home in your portfolio for emerging market exchange traded funds (ETFs). Such ETFs may yield faster growth and potentially higher returns, but they also include their own set of risks.
Developed countries have well-established exchanges that are balanced and reflect the overall market fairly well, remarks Cris Sholto Heaton for IndexUniverse. However, emerging market ETFs can hold sectors that have high weightings out of proportion to their importance to the overall market. A few individual firms, typically energy, mining and materials, financials, real estate and telecommunications companies, are generally very large compared to other firms in developing countries. [Reasons to Stick with Emerging Markets.]
Firms in emerging markets tend to be relatively small or foreign-owned, which makes them underrepresented among listed companies. In other cases, companies may be large and more heavily represented in an ETF because the company is a state-owned firm that is partially privatized. This may force an emerging market ETF to hold a larger portfolio allocation of a specific company and a higher weighting of a single sector. [How Being Underallocated to Global ETFs Could Hurt.]
In some countries with weak competition laws, individuals have developed a strong position in a specific sector that basically enables them to develop a local monopoly. The cash produced from the monopoly is put back into the sector to build a better economy of scale. The result is a single company that is disproportionately larger than other local firms.
Investors should be aware that founding families of monopolies employ a pyramid structure and share classes with different voting rights to maintain control. Minority shareholders are usually ripped off in markets where investor protection is weak or non-existent.
None of this means that you shouldn’t consider emerging markets as a useful portfolio addition. It’s helpful to be keyed in to the world’s different markets to get an overall better understanding of risk. [Know Your ETF Holdings.]