Emerging markets have captured the attention of investors the world over. It's now easier than ever to get access to stock markets across the globe. If you want to make the most of emerging markets, however, you need to go beyond the easy investing methods and dig deeper into what tomorrow's biggest winners will be.
Why emerging markets are more popular than ever
The secret of emerging-market popularity is no secret at all: Emerging markets have performed extremely well over the past decade. Especially when you compare emerging-market returns with those of large-cap U.S. stocks, which have mostly floundered ever since the turn of the millennium, it's no surprise that investor interest in the up-and-coming economies of the world has never been greater.
Corresponding with increased investor interest was the revolution in exchange-traded funds. Utilizing simple index-tracking strategies, ETFs were tailor-made for big, well-established markets, which is why the first ETFs focused on well-known stock market measures like the S&P 500 and the Dow Jones Industrial Average. As ETFs became more prevalent, they spread beyond the headline indexes, following less-tracked indexes or in some cases creating indexes of their own to track.
ETFs have been extremely popular in foreign investing. Because it can be difficult for U.S. investors to buy shares of stocks traded on exchanges abroad, ETFs make it much easier to get exactly the exposure you want. With emerging markets, the iShares MSCI Emerging Markets ETF (NYSE: EEM ) and the Vanguard Emerging Markets Stock ETF (NYSE: VWO ) have duked it out for years, with the Vanguard ETF recently beating out its iShares counterpart for the top spot in assets under management.
The easy way isn't always the best way
Buying an ETF is easy. But it's also a bad way to buy emerging markets. The indexes that emerging-markets ETFs track are laden with heavy exposure to financial and energy stocks, discounting industrials, health-care stocks, and consumer-oriented stocks, all of which will be the true growth story in emerging markets in the years to come.
To get some ideas on stocks to own in those sectors, I turned to the top-performing mutual funds over the past five years. The DFA Emerging Markets Value Fund (DFEVX) owns many of the same financial and energy stocks that you'll find in the emerging market ETFs, including Petrobras (NYSE: PBR ) and ICICI Bank (NYSE: IBN ) . Given their massive run-ups over the past 10 years, holding those big stocks has helped this fund keep up with its benchmarks.
But you'll also find Mexican industrial giant Cemex (NYSE: CX ) , the world's largest cement maker, which has seen its stock languish during the global recession but which is poised to recover strongly as economic activity picks up. Latin American beverage maker Femsa (NYSE: FMX ) also plays a major role in the fund's portfolio, bringing Coca-Cola branded products to the developing world along with beer distribution and convenience stores.
The more interesting of the top two emerging-market funds is DFA Emerging Markets Small-Cap (DEMSX), which has companies that fly under the radar of the major ETFs. As an example, the fund owns shares of Empresas ICA (NYSE: ICA ) , which is an engineering and construction company in Mexico that builds both major infrastructure projects like dams and bridges as well as office buildings and residential property. A variety of companies ranging from auto producers in China and Brazil to retailers in South Africa have helped the fund perform well.
Index funds and ETFs can be a smart way to get exposure in hard-to-reach areas of the financial markets. But when you're not satisfied with market-matching performance -- or when the dangers of a particular index become too great -- then the right move is to seek alternatives. Whether you go with a winning mutual fund like DFA's funds or call your own shots among the hottest sectors of emerging-market economies, going beyond ETFs could be the best investment you'll ever make.
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