Are You Scared of Emerging-Market ETFs?

According to data from ETF heavyweight Blackrock, U.S. investors have a lot less appetite for emerging-market ETFs than their European counterparts do, opting instead for the "safety" of government bonds and gold. While I think it is wise to be wary of emerging-market stocks right now, substituting that exposure for government bonds means jumping out of the frying pan and into the fire. Let me explain why before providing some guidelines for investors who wish to position their portfolios appropriately in this treacherous environment.

U.S. investors ease up on the throttle
In the first fourth months of this year, European investors have added $3.25 billion to emerging-market ETFs -- well ahead of their pace in 2009 (total: $7.5 billion). Meanwhile, U.S. investors have slowed their contributions to this area dramatically, with net inflows of just $1.5 billion so far in 2010, against $27 billion for the whole of 2009. On the back of a huge run-up in emerging markets -- the MSCI Emerging Markets index rose 74.5% in dollar terms in 2009 -- U.S. investors' caution looks well founded.

What will emerging markets return?
Asset manager GMO, which has a good forecasting track record, estimates that emerging-market stocks will earn an annualized after-inflation return of 4.7% over the next seven years. While that certainly compares favorably with forecasted returns for large-cap U.S. equities (+0.3%) and small-cap U.S. stocks (-1.9%), it's not what I would consider an acceptable equity return. After all, you're expecting to receive nearly 2 percentage points less than the long-term historical real return on U.S. stocks (6.5%) to bear the higher volatility associated with emerging markets. That proposition simply doesn't add up.

While the "flight to quality" out of emerging markets is a time-honored ritual during periods of financial turmoil, investors would do well to ask themselves whether traditional "safe-haven" assets still merit that moniker. In particular, government bonds (U.S. and foreign) look like an inadequate choice for investors who wish to protect the purchasing power of their assets.

Not as safe as they seem
Indeed, most of the world's advanced economies now face an unsettling problem with regard to their massive public debt positions. Because of the dollar's role as the world's reserve currency, the U.S. can delay addressing this quandary longer than most other countries can, but it cannot do so indefinitely. The temptation will be for the government to monetize the debt by printing dollars, which does not augur well for fixed-interest securities, including government bonds. Having significantly more dollars sloshing around usually implies that the dollars you are receiving in interest and principal aren't worth what they used to be.

3 recommendations
Let's recap. Here's how I think investors should be positioned regarding the different asset classes that have been mentioned:

  1. Underweight U.S. and emerging-market equity ETFs. This applies to you if you own the SPDR S&P 500 ETF (NYSE: SPY  ) , the Vanguard Emerging Markets ETF (NYSE: VWO  ) , or the MSCI Emerging Markets Index ETF (NYSE: EEM  ) -- or any other ETF that represents these broad asset classes.
  1. Underweight U.S. government bonds. For the reasons cited above, ETFs such as the iShares Barclays Treasury 20+ Year Bond ETF (NYSE: TLT  ) are unlikely to produce adequate returns for their shareholders over the long term.
  1. Overweight gold. For individual investors, the cheapest, most convenient way to participate in this market is the SPDR Gold Shares (NYSE: GLD  ) . Readers may legitimately wonder what "overweight gold" corresponds to in terms of a figure. At the end of 2008, the value of all mined gold represented approximately 2.8% of the aggregate worth of global financial assets; I'd suggest that twice that number might be a suitable allocation today. Prominent value investors Chuck de Lardemelle and Charles de Vaulx of International Value Advisors have a 6.5% stake in gold bullion in their IVA Worldwide Fund, for example.

Gold: Winner takes all?
Should the increased allocation to gold be equivalent to the reductions in equity weightings? No, the rebalancing out of equities shouldn't benefit gold exclusively -- that would give it too high a weighting in your portfolio. Given the lack of attractive opportunities at the asset-class level, I think investors should be overweight cash, too. Cash doesn't earn you anything -- except the flexibility to bid on assets once their prices have been knocked down to more attractive levels. I expect that investors will be able to exercise that privilege over the next 12 months.

While emerging markets as a whole look likely to disappoint, there are individual stocks in these economies with huge growth potential. Tim Hanson takes you through the only way to earn 50% annual returns.

Fool contributor Alex Dumortier loves macro-themed investing. Alex has no beneficial interest in any of the shares mentioned in this article. The Fool owns shares of Vanguard Emerging Markets Stock ETF. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (4)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 19, 2010, at 5:39 PM, goalie37 wrote:

    I am afraid of all stock based ETFs. How can you assign a proper valuation to a basket?

  • Report this Comment On May 19, 2010, at 6:21 PM, megalong wrote:

    Jeremy Grantham at GMO disagrees with your conclusions. He recommends being overweight large US stocks and emerging markets.

    Largecap dividend paying stocks are more likely to hold value and appreciate than cash and gold if optimism stretches out a few years before we see very low prices again.

  • Report this Comment On May 19, 2010, at 7:06 PM, ChrisBern wrote:

    @megalong--

    The author is correct, and Jeremy Grantham is wrong. :)

    Obviously we're all speculating on what WILL happen. But there are significant headwinds facing currencies and equities right now, particularly in heavy-debt countries like the U.S. One of the last places I would have money right now is in U.S. equities, large cap or otherwise, dividends or no dividends. Over the next decade, I believe it to be quite unlikely that capital gains will exceed currency depreciation, and in fact, I fully expect the S&P 500 to be a net loser over the next decade once adjusted for inflation. But nobody knows for sure...

  • Report this Comment On May 19, 2010, at 7:29 PM, TMFAleph1 wrote:

    megalong,

    Thanks for your interest. I'm pretty certain Grantham doesn't recommend being overweight large-cap U.S. stocks indiscriminately -- it's high-quality, large-cap stocks he likes. There is no way he would recommend being overweight in large-cap U.S. stocks when he expects them to earn just 0.3% above inflation over the next seven years -- GMO's forecast has U.S. government bonds doing better than that.

    I'm less familiar with his position on emerging market equities -- I'll have to look at this in more depth. In general, Grantham is one of the few people in Finance worth listening to.

    Best,

    Alex D

  • Report this Comment On May 19, 2010, at 10:53 PM, TMFAleph1 wrote:

    @goalie37,

    Thanks for your comment.

    No need to be scared. In many cases, it's easier to value an ETF than a single stock because you have the Law of Large Numbers on your side, i.e. the statistical properties of an index (for example P/E or EPS growth) are more stable than those of single stock. This one of the reasons why I prefer asset allocation investing to stockpicking.

    Best,

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