Invest Smarter in Emerging Markets

ETFs are a great way to get quick exposure to a particular market. But you shouldn't make any assumptions that any particular exchange-traded fund invests in the stocks you think it ought to own, no matter how reasonable it may seem based on the name of the investment objective of that ETF.

Emerging market ETFs provide a great example. Many investors are attracted to the growth opportunities in emerging markets right now. So you'd expect that the stocks an emerging market ETF would invest in would be stocks that are best positioned to benefit from that growth. Unfortunately, many ETFs have a far different investing philosophy than that -- and it might lead you to investments that aren't as compelling for you.

Adding emerging flavor to your portfolio
Emerging markets have captured the attention of investors for a variety of reasons. First and foremost, economies like China, India, and Brazil have stood up quite well during the global recession over the past couple of years. While many GDP figures contracted for developed economies, all the recession did for many emerging markets was to slow down red-hot growth rates to more modest figures. And after that brief pause, many of those markets are resuming their upward climb without looking back.

But to fully understand the emerging market economies, you have to look closely at what's driving that growth. As you'd expect from these populous countries, personal consumption is a big driver of economic activity, creating a positive feedback loop whereby an emerging middle class is becoming more prosperous and thereby fuels continuing consumption, creating jobs and elevating more people into their ranks.

You might expect that in choosing investments, an ETF would pay attention to these trends and invest accordingly. But a closer look reveals otherwise.

Focusing on Brazil
According to figures from Neuberger Berman, Credit Suisse, and Merrill Lynch, the dominant force in Brazil's economy is internal private consumption -- that is, ordinary people spending money on ordinary things. Gross exports make up just 11% of GDP.

Based on this, you might expect to see the iShares MSCI Brazil ETF (NYSE: EWZ  ) composed largely of consumer-oriented stocks. Yet ETF shareholders will find themselves heavily invested in resources stocks Petroleo Brasileiro (NYSE: PBR  ) and Vale (NYSE: VALE  ) , as well as banking giants Banco Bradesco (NYSE: BBD  ) and Banco Santander (NYSE: BSBR  ) . Together, energy, materials, and financial stocks make up nearly 75% of the ETF's value -- despite their relatively minor contribution to the Brazilian economy.

Granted, the iShares Brazil ETF doesn't leave out consumer stocks entirely. Brasil Foods (NYSE: BRFS  ) and Cosan (NYSE: CZZ  ) make appearances in the portfolio. But overall, consumer stocks make up just 14% of the ETF's assets -- a big discrepancy from the way the economy looks.

There's nothing inherently wrong with banking and resource stocks. Over the years, they've done quite well for their shareholders. But the future prosperity of Brazil will show itself in consumer stocks.

Fixing the problem
If you want to own a portfolio of stocks that's truly representative of an emerging nation's economy, then you have several choices. One is to seek out different ETFs that focus on the areas that other ETFs miss. For instance, the Global X Brazil Consumer ETF (BRAQ) focuses entirely on consumer stocks, so combining it with the iShares offering lets you balance your overall Brazilian exposure in any way you want.

Another choice is to buy individual stocks that the ETFs don't give enough weight to or leave out entirely. That's useful if there's a particular industry or company that you believe will stand out from the rest of the economy going forward.

Finally, you can recognize that the global economy makes it possible for consumer giants outside the emerging nations to capitalize on a growing middle class. Buying U.S. and other developed-country consumer stocks may give you just as much exposure to emerging market growth as buying shares of a locally based company.

Get what you want
The biggest benefit of ETFs is that every day, you can see what your fund owns. But you have to use that knowledge. If your ETF isn't investing in the stocks you want to own, then take steps to make sure you get the asset exposure you're looking for.

ETFs aren't perfect, but the right ones can serve you well. Click here to read The Motley Fool's free report, 3 ETFs Set to Soar During the Recovery.

Fool contributor Dan Caplinger tries to invest smarter every day. He doesn't own shares of the companies mentioned in this article. Petroleo Brasileiro is a Motley Fool Income Investor pick. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy makes you a smarter person, guaranteed.


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