The Wrong Way to Invest in Emerging Markets

Investors may be souring on stocks this year, but they are not souring on international markets. That's clear given that while $38.5 billion flowed out of domestic stock funds through the end of August, $28.2 billion flowed in to foreign investments so far this year.

There are a myriad of reasons why increasing your portfolio's international exposure is a savvy long-term move, including slowing U.S. growth, a cash-strapped consumer, a weakening dollar, and so on. But rather than rehash those reasons (and again, based on the data, it looks like investors are already well aware), I want to address a mistake that many individual investors are making in choosing how they get their international exposure.

The world's most popular ETF
When it comes to international investing, the most popular vehicle out there is the iShares MSCI Emerging Markets Index (NYSE: EEM), with an astounding $41.7 billion worth of assets. Yet aside from the facts that the iShares MSCI Emerging Markets Index has been around since 2003 and that iShares is pretty good at marketing, there are two very good reasons why this ETF should not be the most popular for investors to gain emerging markets exposure.

The first reason is because EEM is not the cheapest option in the category. That honor belongs to Vanguard Emerging Markets Stock (NYSE: VWO), which with a 0.27% expense ratio checks in almost 50 basis points cheaper than the iShares offering. The second and more important reason, however, is because EEM is playing emerging markets all wrong.

Let's look under the hood
Take a gander at EEM's top 10 holdings:

Data from Morningstar as of July 31, 2010.

Within those top 10 holdings alone we have three companies (Samsung, Taiwan Semiconductor, and Infosys) whose sales are more closely tied to developed markets than to emerging markets, four companies (China Mobile, Gazprom, Petrobras, and Vale) that are controlled to some extent by their governments and that may or may not be being run in the interests of shareholders, and three banks. All, of course, are also enormous.

If you own EEM or are thinking about owning EEM, then this should prompt you to ask: Are the fastest-growing parts of the world's emerging markets over the next few years going to be export manufacturing, outsourcing, banking, and globally priced commodities? And will the fastest-growing emerging markets companies be mega caps? While there's something to be said for the retail banking sector in underbanked markets such as India and Brazil, the rest of it is nonsense. Those sectors are historically where emerging markets have been; not where they're going.

That's what you're getting with EEM
These problems extend across EEM's portfolio well beyond its top 10 holdings. The fund is sitting on a massive 25% position in financial stocks and has another 28% invested in materials and energy:

That overexposure, of course, comes at a cost. Specifically, EEM is significantly underexposed to the industrials sector that is building much needed infrastructure in India, Brazil, and the like as well as to the fast-growing consumer and health care sectors. In India, for example, consumer spending on prescription drugs is one-seventieth what it is in the United States and less than 2% of the country's more than 1 billion residents have health care coverage. While it will take some time for India's health care industry to catch up with the rest of the world, what those incredible statistics show is how much growth potential the sector has -- potential that doesn't exist in the well-developed energy or banking sectors. And that fact is already showing up in EEM's returns. Although the fund is up more than 50% over the past 5 years, that return significantly lags the 110% return generated by an equal-weighted composite of the Chinese, Brazilian, Indian, Mexican, and Indonesia indices -- a far more representative emerging markets benchmark.

A different view
Now take a look at a look at the sector breakdown of our stock recommendations at Motley Fool Global Gains.

We've recommended some 26% consumer exposure, 19% industrial exposure, 14% telecom exposure, and 7% health care exposure. This represents a dramatically different and much more forward-looking view of the investment opportunities in emerging markets than what you'll get buying EEM.

Of course, if you believe emerging markets will remain commodity-based oligarchies, then EEM is the vehicle for you. But if you think emerging markets are entering a new era of rising consumer spending power, infrastructure development, and more diverse, sustainable development, then there are better and far more profitable ways to play that belief than via the iShares MSCI Emerging Markets index.

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