Using ETFs to Round Out Emerging Markets Exposure

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Last week, EGShares rolled out a suite of sector-specific emerging markets ETF, each focusing on various corners of the economy of the developing world. These products could obviously be useful to more active traders utilizing a sector rotation strategy in emerging markets, seeking to shift exposure towards corners of the market that maintain promising potential for capital appreciation and away from those that seem overpriced. But some of the most recent additions to the ETF lineup could also be effective tools for those with a longer-term focus, as they allow for the ability to fine tune international equity exposure and construct a more balanced portfolio.

The two most popular options for broad-based emerging markets exposure are both linked to the MSCI Emerging Markets Index; EEM and VWO have aggregate assets of close to $85 billion. There's a lot to like about these funds; the underlying index includes about 800 individual stocks from more than a dozen developing economies, and both products are extremely cost efficient (though VWO is quite a bit cheaper than its counterpart).

But there are some biases in these products that might be of concern to some investors. Like many international equity ETFs, they are tilted heavily towards certain sectors of the economy. Because the largest companies in most markets tend to be banks and oil firms, the allocations to the financials and energy sectors have a tendency to dominate the portfolios. These two sectors, along with materials companies, combine to make up about half of the assets in these popular products. At the other end of the spectrum are segments of the emerging markets economy that receive virtually no weighting; utilities account for only about 3% of EEM and VWO, while health care stocks represent a measly 1% of the underlying portfolio [Never Judge An ETF By Its Cover].

Balancing Act
For some investors, that tilt towards certain sector may be just fine; the exposure offered is, after all, representative of the economy of the aggregate emerging markets. But others might wish to maintain a more balanced portfolio that limits exposure to any one segment of the economy -- especially considering the dependence of energy firms on crude prices and potential volatility within the financial sector. Sector-specific emerging markets ETFs give investors the potential to beef up weights to those corners of the market overlooked by broad-based funds, making them potentially useful complementary holdings for those who achieve the bulk of emerging markets exposure through iShares MSCI Emerging Markets Index (NYSE: EEM  ) and Vanguard MSCI Emerging Markets ETF (NYSE: VWO  ) .

EGShares Health Care GEMS ETF (HGEM)
The health-care sector in emerging markets represents a tremendous growth opportunity, yet receives almost no weighting in most broad-based emerging markets funds. Much has been made of the positive impact of urbanization on consumer companies; as emerging markets populations move to cities and graduate to the middle class, discretionary income spikes and desire for goods such as televisions, cars, and air travel will also rise. Those same factors could have a positive impact on the health care sector over the long run; higher quality of life and increased wealth will translate into demand for pharmaceuticals, health care providers, and medical supplies and equipment -- four health care sub-sector that make up the HGEM portfolio.

HGEM includes 30 health care stocks, with the heaviest allocations going to India (39%), South Africa (23%), and China (16%).

EGShares Utilities GEMS ETF (UGEM)
Similar to their role in many U.S. equity funds, utilities stocks have the potential to bring stability and attractive current returns to an emerging markets portfolio. But unlike their developed market counterparts, emerging markets utilities may also maintain significant growth potential. The rapid growth of urban areas across the emerging world means demand for infrastructure and electricity should continue to skyrocket, creating opportunities for expansion. In China alone, the projected growth figures are staggering. According to a report by McKinsey & Company, more than 350 million people are expected to move to Chinese cities in coming years. That will double the number of cities with at least one million residents to more than 220 and require the construction of tens of thousands of new skyscrapers (by comparison, there are nine U.S. cities with at least one million residents). Other emerging markets in Asia and Latin America are experiencing similar trends -- albeit perhaps not on the same scale as China.

Most investors who have embraced ETFs have very little in the way of exposure to emerging markets utilities; VWO's portfolio allocates only about 3% to this segment of the developing world. Those looking to step up this weighting might find this ETF to be a useful tool. UGEM's portfolio consists primarily of conventional electricity firms (54%) and alternative electricity companies (30%), with the remainder of assets attributable to gas distribution, water, and multiutilities. The fund includes nine different countries; in addition to each of the BRIC bloc, Chile, Colombia, the Czech Republic, Malaysia, and Poland are represented [also see Emerging Markets, Inflation, and ETFs: Q&A With Richard Kang].

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