This Is the Way to Play Asia

Want to see an awkward conversation? Lock me in a room with an ardent believer in the efficient market hypothesis. It won't be but a few minutes before my interlocutor and I are both clawing at the walls.

I know this because I had the misfortune of having a few conversations like that earlier this week at a conference of financial planners where I was a guest speaker. That's because financial planners tend to be passive investors who favor a passive, index-based approach to equities. While index funds are a fabulous low-cost investing solution for the majority of investors out there, I continue to believe that careful stock selection can add a lot of value to one's portfolio -- a fact that's particularly true in volatile times like these, and in volatile markets like those of the emerging world.

But rather than get too far into that debate (again, I got my fill earlier this week), let's focus for a moment on the bigger picture: There are plenty of investors out there who need emerging markets exposure who only want to invest via index funds.

The problem with emerging market indexes
If you're a regular reader of this column, then you know that I have big problems with the composition of the most popular emerging markets index, the iShares Emerging Markets Index (NYSE: EEM), as well as with popular country-specific indexes such as China's iShares FTSE/Xinhua 25 (NYSE: FXI). Not only are these indexes the wrong way to invest in emerging markets, but their methodology -- which weights holdings by market cap -- has overexposed investors to the financial and natural resource sectors as well as to multinationals that, while headquartered in relevant emerging markets, are more closely tied to economic activity in the developed world.

This is a problem because emerging markets exposure should offer you at least two benefits over the next few decades: better-than-average growth prospects and returns that correlate less and less with the returns of the developed world. Due to the realities mentioned above, those popular emerging markets ETFs just aren't getting the job done.

Yet if you're an investor looking for legitimate emerging markets exposure who does not want to pick your own stocks, there is good news. There are several high-quality actively managed funds and overlooked ETFs out there that would make sound additions to your portfolio. To demonstrate that that's true, I want to reveal our favorite fund for emerging Asia.

The way to play Asia
When it comes to fast-growing economies of China, India, and the rest of emerging Asia, many investors have opted for the aforementioned iShares FTSE/Xinhua 25 index, with $9 billion under management, or the iShares MSCI Pacific ex-Japan Index (NYSE: EPP), with more than $4 billion under management. Yet these funds don't stack up next to a superior choice, and the fund we prefer for emerging Asia exposure at Motley Fool Global Gains: Matthews Pacific Tiger (MAPTX).

The reason is that while the Matthews fund carries a higher expense ratio (1.13%), it's earning those fees through more thoughtful portfolio construction, as evidenced by a comparison of each fund's top 10 holdings:

Data from iShares and Morningstar.

My guess is that no one who wanted to invest in China or emerging Asia wanted quite so much exposure to Chinese banks, which are state-run and facing a potential loan quality crisis, or to Australia and its banks, which are caught up in their own housing bubble of enormous proportions.

The Matthews fund, on the other hand, has fewer funds concentrated in its top picks, offers more even country exposure, and has relatively overweighted its position in consumer stocks -- a prudent move given the rapid growth in the consumer sector in these markets and efforts, specifically in China, to even out development between the haves in tier 1 cities such as Beijing and Shanghai and the have-nots working on small farms in rural China. Will this strategy pay off going forward? Although past performance is no indication of future results, Matthew's more forward-looking approach to Asia's emerging economies has helped it best its peer group by more than three percentage points annually over the past decade.

Think about what you own
Although low-cost index funds are successful and time-tested investment options, the fact is that the space is relatively immature when it comes to emerging markets. Further, given the fact that emerging markets are relatively immature economies themselves, the market cap-weighted approach can have extremely distortive effects -- which is why the FXI investor ends up owning so many Chinese banks.

This is why emerging markets represent such an exciting space for individual investors who are willing to pick their own stocks. Many are small and overlooked by the broader market, creating compelling opportunities for those willing to learn more.

Yet I know that many investors want to simplify the process and stick with funds. That's fine, but before you add any emerging markets fund to your investment portfolio, think critically about the assumptions and holdings that it represents. A fund that's more than 60% invested in Australia, for example, as the iShares Pacific ex-Japan index is, really won't help your portfolio profit from growth in China and India. And while you will pay more for an actively managed choice such as Matthews Pacific Tiger, sometimes you do get what you pay for.

Get Tim Hanson's "Global View" column every Thursday on Fool.com or by following him on Twitter.