Since the advent of exchange traded funds (ETFs), investing globally has never been easier. ETFs are an effective way to gain exposure to foreign investments without the hassle of accessing foreign stocks through specialized brokerage accounts or spending countless hours researching individual overseas companies.
Though the diversified structure of ETFs mitigates your risk, there are not only risks existing in emerging market and frontier market ETFs, but there are varying levels of this risk.
That doesn’t mean you should be scared off by these funds. With most of the world’s market cap residing outside of the United States, emerging and frontier markets deserve a home of some sort in most portfolios. It’s all just a matter of selecting what’s right for you.
The Benefits of Investing Globally
Whether through a country-specific ETF or a broad/regional international ETF, investing in emerging and frontier markets provides diversification to an otherwise bland portfolio. How much international exposure should you have in your portfolio? Some experts suggest that around 25% is a good guideline, but this is up to each individual.
Internationally themed ETFs trade on a U.S. exchange and aim to reflect an underlying index that correlates to a particular country or region. This may result in higher volatility since other countries’ exchanges will be trading in different time zones.
What do you and your clients stand to gain by investing globally? Several things:
- Gains by U.S. investors in overseas markets have enjoyed a “dollar kicker” when assets are repatriated to U.S. dollars.
- Country-focused ETFs are a good way to aim a portfolio at weighting countries more on growth potential rather than market capitalization; this way, any growth potential is harnessed and none of those gains are left out.
- Single country funds also make plays upon other areas; for example, Australia can give good exposure to commodities, and is in the position to spot most of China’s growth; Singapore’s ETF also has high exposure to industrials and telecommunications.
- By using the single-country ETFs, it is possible to challenge the larger conventional indexes, and still garner the diversification and gains.
The definition of “emerging market” varies depending on who you ask, but generally speaking, these economies have a low- to middle-per capita income per person. They might sound like small fry, but these countries account for 80% of the world’s population. They’re considered emerging because of where they are with infrastructure, reforms and the practices of their governments. These economies are in transition, progressing from closed to open market economies.
With developed economies expanding at a crawl, more emerging markets are turning inward for growth instead of relying so heavily on exports. A growing middle class in most of these countries has fueled domestic demand. High levels of government spending on infrastructure projects has helped to maintain the needs of the growing middle class.
There are a number of these markets represented by ETFs: Brazil, Russia, India and China (collectively know as the BRICs). There is Indonesia, Malaysia, Thailand and Singapore. Or there’s Poland, South Africa and the Czech Republic.
Frontier markets are those markets loosely defined as a country or region a notch below emerging markets. They’re considered to have further to go on the development scale, but they’re not lacking promise. This group includes most African countries, some southeast Asian countries, a few Latin American countries and parts of eastern Europe.
Frontier markets are either smaller than traditional emerging markets or include countries that restrict foreign investments. These markets are exceptionally risky, but investments in frontier markets offer above average returns over time. Additionally, frontier economies have a low correlation with traditional investments.
You would invest in these economies because although you recognize the greater risk, you also see the enormous potential for growth. These economies have further to go than emerging markets, which means that as they develop, there’s greater reward.
Building a Portfolio
When building a portfolio that contains emerging and frontier market ETFs, there are a number of things to consider:
- Country risk, or the economic, political and business risks unique to a specific country or region, might result in unexpected losses. Emerging and frontier markets are in the midst of rapid industrialization and provide higher levels of growth, which may result in higher investment returns. But this greater political uncertainty often results in more frequent booms and busts. Investors should consider an emerging market’s economic and financial fundamentals and political climate.
- Economic risk is a country’s ability to pay back debts. Countries with stable finances should be able to withstand economic shocks better than weaker or unsound economies. One way to determine a country’s ability to repay debt is through ratings agencies like Moody’s, Standard & Poor’s, Fitch or other large ratings agencies. Countries with higher credit ratings are considered safer investments as compared to those with lower ratings. Additionally, one may scrutinize a country’s gross domestic product (GDP), inflation and consumer price index (CPI).
- Political risk refers to the political decisions made within a country and the possible unanticipated loss that may result. Frontier and emerging markets often have corrupt governments or the kind of political infighting that hinders or stalls growth altogether.
Now that you’re aware of the risks and know what to be mindful of in such economies, there are ways to control your overall exposure to these risks and their effects.
You will first need to ask yourself what kind of exposure you want to a particular economy. Narrow exposure, such as what’s seen in a single-country fund, can be more volatile and risky, but it also allows you to fully capitalize on any strides a single country makes.
On the other hand, broader exposure can help you on two fronts:
- It spreads out the risk you may be taking on in a single-country fund by giving you exposure to a wide range of markets
- It eliminates the need to predict which countries will perform the best, allowing you instead to just hold all of them
The downside, of course, is that you wouldn’t be able to reap the full rewards of any one country’s performance.
After you’ve chosen an ETF or two, compare them by looking under the hood at several elements:
- Asset size. What are the fund’s assets under management? The more assets, the more liquid an ETF tends to be. Any ETF you consider should have at least $50 million under management.
- Trading volume. This is an indicator of how actively an ETF is being traded. If you have lots of buyers and sellers, your fund will be more liquid. Look for trading volume around an average of 100,000 shares a day.
- Underlying holdings and sector weightings. What sectors are held within the fund? Is the ETF you’re inspecting more of an energy play, or does it have heavy exposure to financials? How does it fit in with your current portfolio holdings?
- Country weightings. How many countries are held within the fund? What are their weightings? There’s no right or wrong answer to this question. It depends on what you’re looking for as an investor.
- Fundamentals. What’s happening in these markets? Consider what’s happening in the world that could positively or negatively affect the fortunes of global economies.
- The trends. Most importantly, is the trend there? We use a 200-day moving average discipline for clients. We take positions when the trend is above the 200-day, and we exit them when it drops below. This strategy will have you in to take advantage of any potential long-term uptrend, and out before your losses become too great.
If you’d rather not build your own portfolio, remember that you can choose from one of our several model portfolios, as well.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.