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 Emerging markets via the ASX - Eureka Report article 

August 18, 2008
Emerging markets via the ASX
By Scott Francis

PORTFOLIO POINT: The iShares EM exchange traded fund offers investors access to the potential long-term outperformance of emerging markets.


The Australian dollar has fallen 10% in recent weeks, leading to unhedged shares in emerging markets rebound about 2.3% since July 1. This is hardly enough to have investors packing for an extended holiday in the French Riviera, although it is nice to see one growth asset class providing reasonable returns after a dismal time in investment markets.

This 'Close up' article takes a look at the iShares Emerging Markets Exchange Traded Fund (ETF). Similar to an index fund, an Exchange Traded Fund is an instrument that aims to mirror a particularly index, in this case the Morgan Stanley Capital International (MSCI) Index. The MSCI is key indicator of global markets. The MSCI EM (emerging markets) is a "sub-set" of the MSCI which, as you would expect, indexes emerging markets.

The key difference between and ETF and an index fund is that the ETF is listed on the stock exchange. In practice this means the fees for ETFs are cheaper than index funds but the price of the fund can be much more volatile, reflecting how prices move on a public exchange.

You can buy ETFs as you would usually trade shares, through either a discount or full-service broker. The stock code for the iShares Emerging Markets ETF is IEM.

What are emerging markets?

Emerging markets are those with developing economies. Examples of these economies include the BRIC economies (Brazil, Russia, India and China). The expectation is that these economies are still very volatile but with the capacity to grow at a higher rate than developed economies, and provide investors with higher returns. This fits in with the conventional investment that risk and reward are related. Emerging Markets exposure offers higher potential returns with greater risk (volatility).

Emerging markets performance

To the end of July 2008, Australian shares have provided an average return (as measured by the ASX 300 index) of 8.7% a year over three years and 14.39% a year over five years. Over the same period, emerging markets shares (as measured by the MSCI Emerging Markets Index) have provided a return of 14.31% a year over three years and 18.02% a year over five years. This demonstrates that over this three and five-year period, there has been a "premium" for investing in emerging markets.

It is worth keeping in mind that this premium is not risk-free: the expectation is that emerging markets exposure is more volatile and therefore would underperform developed markets over some periods.

The iShares Emerging Markets ETF has been listed in the US since April 7, 2003. To March 31, 2008, it has provided an average annual return of 22.49% in Australian dollar terms (that is, for an Australian investor).

The iShares Emerging Markets ETF has been listed in the US since April 7, 2003. To June 30, 2008 (just over five years), it reported an average annual return of 20.66% in Australian dollar terms (ie, for an Australian investor). The actual underlying investments had provided a return of 32.11% in US-dollar terms, with the appreciation of the Australian currency reducing the return for Australian investors.

Risks

Emerging markets are subject to political, economic and legal risks. Consider China: its government is a communist dictatorship and its legal system and property rights are far less certain that in a developed economy. In fact, most Chinese companies are majority government-owned. This offers investors far less certainty when compared to an investment in a developed economy.

Currency hedging

Whenever you invest overseas, the question is always whether or not to "hedge" currency movements. As explained in a previous article (see Careful how you hedge your bets), my preference is for currency unhedged exposure. These reasons for this include:
  • There is a cost associated with hedging.
  • There are negative tax consequences of hedging.
  • An unhedged portfolio is less correlated to Australian shares, which provides an investor with a greater diversification benefit.

The iShares Emerging Markets trust is unhedged.

Costs

The MER (management expense ratio) of the iShares Emerging Markets ETF is 0.74%. This would seem to compare somewhat unfavourably with the iShares ETF that tracks the S&P 500 index, which has an MER of 0.09%. However, this difference in fees is understandable because it is more expensive to invest in emerging market companies than in a developed stockmarket like the US. However, it compares very favourably with the high (often 2%) MERs applied to international share funds among traditional managed funds

Other emerging markets exposure

As well as the iShares Emerging Markets ETF, investors can gain access to this asset class through more traditional index funds or through active managed funds. There has been a significant increase in the number of funds offering emerging markets exposure, and this is likely to continue. The iShares EM ETF is one of a series of specialist ETFs launched last year by the Barclays group on the ASX. (To read more, see iShares' world view.)

Within a portfolio

I think it makes a great deal of sense to have some emerging markets exposure within a portfolio. It is likely not to be a huge part of any portfolio, however a 3-10% exposure provides additional diversification to an asset class with a higher expected long-term return.

Conclusion

The case for some emerging markets exposure in portfolios is relatively strong; they add additional diversification and a potential long-run outperformer.

Campbell Harvey, from Duke University, summed up emerging markets exposure in his paper Predictable Risk and Returns in Emerging Markets, available at the Social Service Research Network.

Harvey commented on the fact that emerging markets exposure offered higher returns but with higher risk, while offering a potential diversification benefit within portfolios. His conclusion with regard to these factors is that "inclusion of emerging market assets . will significantly reduce portfolio volatility and increase expected returns".

The iShares Emerging Markets ETF would seem to offer a simple, reliable and comparatively cost-effective way to get that exposure.

Scott Francis' articles in the Eureka Report 

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