Best ETF for 2012: Vanguard MSCI Emerging Markets

This article is part of our Best ETFs for 2012 series, in which we're seeking out the top-performing ETFs for the coming year.

My pick for best ETF for 2012 is quickly becoming a portfolio classic; it's the Vanguard Emerging Markets Index ETF (NYSE: VWO). In fact, I like it enough to add it to my CAPS profile today -- you can follow my performance here.

Before we get into the thick of things, I should start by pointing out that this ETF tracks the MSCI Emerging Markets Index, but it isn't the only ETF to do so. BlackRock offers the iShares Emerging Markets Index Fund (NYSE: EEM). Why choose the Vanguard ETF? Vanguard is simply more shareholder-friendly and more cost-conscious. The impact on the bottom line, your bottom line, is material, particularly if you expect to hold the ETF in your portfolio over a number of years. The Vanguard ETF's expense ratio is 0.22%, whereas the iShares equivalent's is 0.69% -- nearly half a percentage point more expensive. That kind of difference adds up over time!

Let's take a look at one of the Vanguard ETF's holdings to illustrate the kind of opportunity the emerging markets represent. One of the top 10 holdings is Itau Unibanco Holding (NYSE: ITUB), at No. 8. The product of a 2008 merger, Itau Unibanco is the largest bank in Brazil -- in fact, it's the largest in Latin America. As the Brazilian economy continues to create wealth and the size of the middle class increases, banking -- and specifically mortgage lending -- is an activity that has excellent growth prospects. Two factors explain this: One is the growth in the middle class that I just referred to, but that isn't the whole story. The second factor is an example of the way in which emerging economies and their societies are changing to create new product and service markets (if you want another example, look no further than "The Motley Fool's Top Stock for 2012").

Until the last several years, most homebuyers in Brazil were cash buyers -- it was almost impossible to obtain a mortgage. Lenders were not motivated to offer mortgages with the property as collateral because the law made it very difficult to foreclose on a delinquent borrower. In 2005, the year in which these laws were updated, loans secured against real estate amounted to just 1.4% of GDP. Today, the figure is nearer 5%, which still leaves plenty of opportunity for growth if you consider that even emerging economies such as Bulgaria and Hungary have residential mortgage-to-GDP ratios of 13% and 17%, respectively.

The ETF's top 10 holdings also include three energy and commodities stocks: Petrobras (NYSE: PBR), Vale (NYSE: VALE), and Gazprom. If you believe we are in a commodity super-cycle driven largely by Chinese demand, then these companies certainly stand to reap the benefits. The former two stocks, both of which trade on the New York Stock Exchange, look attractively priced right now.

What about the valuation of the ETF itself? An incapacity to be value-conscious has been the downfall of many emerging-market investors. Hypnotized by the siren song of growth, these intrepid sailors go crashing into the shoals of disappointing returns. At roughly 15 times earnings, this index is cheap enough to begin buying, but it is not yet at the type of valuations that would justify lifting every offer in the market.

Past returns show that emerging-market stocks have had a very good run over the recent past and over the prior 10-year period -- the five-year annualized return is low because the starting point is in the fourth quarter of 2006, when stocks in emerging and developed markets alike were beginning to peak. Returns are mean-reverting, so unless you believe that 15% is a normal long-term return for these stocks (I don't), you should expect to earn less than that over the next 10 years.

Sources: iShares, State Street Global Advisors. As of Nov. 30.

How much less? Fund manager GMO's expertise is asset allocation. According to their asset-class return forecasts -- which are among the most reliable estimates out there – emerging-market stocks will produce a real return of 5.6% on an annualized basis over the next seven years. You might be asking yourself why'd you want to own an asset with an expected return of less than 6%. First, let me emphasize that this is a real -- i.e., inflation-adjusted -- return. Second, that beats four of the other five equity sub-asset classes GMO presents in its forecast, the exception being international large-cap, with an expected return of 5.8%:

Source: GMO.

Bottom line: A highly diversified index fund like Vanguard MSCI Emerging Markets is a relatively low-risk and certainly low-cost way to own exposure to the emerging markets. These markets are no longer a high-risk novelty item for the adventurous; they are now a standard -- you might even say necessary -- part of any investor's asset allocation. At current valuations, the Vanguard Emerging Markets ETF is an excellent way to begin filling that allocation.

Stay tuned throughout our series on the Best ETFs for 2012 to find out about all of the picks our Foolish contributors have made. Click back to the series intro for links to the entire series.