These ETFs Are Dangerous

Many investors I talk to want to increase their exposure to emerging markets abroad. However, they don't feel qualified to analyze individual companies' stocks beyond the United States. Instead, they take advantage of the recent growth in country-oriented exchange-traded funds (ETFs) to buy a single diversified position in a country that they believe has meaningful long-term growth potential. Unfortunately, this seemingly elegant approach can be more dangerous than they suspect.

Many country-oriented ETFs don't necessarily give investors the exposure they're looking for. These ETFs are generally tied to market cap-weighted indexes, which tilt exposure toward big companies in long-developed industries. These relative titans may not share the same growth potential of the underlying emerging market they call home.

Six dangerous examples
Consider these popular emerging markets, and the ETFs that are ostensibly good proxies for investing in them:

Source: iShares and PowerShares.

As you can see, when you buy one of these funds, you may not be getting the exposure you're hoping for. This is perhaps most glaring in China, where buying into the iShares FTSE Xinhua 25 Index will net you a whopping near-50% position in state-run Chinese banks, and just 2% exposure to the Chinese consumer.

Chinese banks were recently asked to stress test for a 50% to 60% decline in housing prices; many of them have spent the summer looking for new capital. Chinese consumers, on the other hand, are sitting on virtually no debt and $2 trillion in spending power. Which sector would you rather have exposure to?

A Mexican company that's not all that Mexican
Then there's iShares MSCI Mexico, which stashes a whopping 27% of its assets in America Movil (NYSE: AMX). Although this telecommunications company is headquartered in Mexico and run by Mexican billionaire Carlos Slim, the firm actually derived just 40% of its sales from that country in 2009. More than $6 billion came from Brazil, with almost $2 billion from the United States. America Movil is a fine company, and Mexico is an important part of its operations. But if you're looking for direct exposure to a rebound in the Mexican economy, you'd  be better off owning smaller companies such as Banco Compartamos or Grupo Aeroportuario Centro Norte (Nasdaq: OMAB).

Similarly, it's a little bit shocking that iShares MSCI Brazil offers just 2% exposure to Brazil's profitable telecommunications industry. In part, that's because the fund can't hold shares of Mexico's America Movil. In addition, Brazil's index is heavily dominated by banking and commodity heavyweights. Yet these are the two most developed parts of Brazil's economy, and they don't share the same growth prospects as more consumer-oriented companies such as Redecard, Natura Cosmeticos, and MercadoLibre (Nasdaq: MELI). Although that last name is expensive, it's a long-term play on the Brazilian consumer -- Brazil is the company's largest market, and it contributed more than 40% of its marketplace revenue in 2009 -- even though it's headquartered in Buenos Aires, Argentina.

Finally, the PowerShares India fund's No. 1 holding, with more than 10% of assets, is Infosys (Nasdaq: INFY). The India fund holds more than 16% of its assets in the information technology space overall. This represents a massive bet on outsourcing -- not a bet on India at all, but a bet on continued corporate spending in the United States and Europe. In fiscal 2010, for example, almost 90% of Infosys' sales went to the United States and Europe, while just 1% came from India itself. Given that fact, I expect outsourcing to be among the slowest-growing segments of the Indian economy going forward. I believe investors are much better off looking at the country's consumer, banking, and infrastructure sectors on their own.

Be careful what you buy
Although ETFs offer diversification and convenience, too many country ETFs aren't constructed to provide good solutions for intelligently increasing your emerging-markets exposure. Instead, your best bet is careful stock selection or a low-cost, actively-managed fund. There's simply no excuse for inadvertently ending up overweight on Chinese banks.

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