5 Excellent ETFs for Emerging Markets

Developing-markets stocks have been struggling in 2011, but that’s no reason to avoid investing in them.

Emerging-markets stocks are short of breath, which is understandable. Over the previous two years, and for most of this millennium, the stock indexes in up-and-coming countries blew away the Dow Jones industrial average, the Nasdaq 100 index, Standard & Poor’s 500-stock index and other popular benchmarks in the developed world. But now it’s 2011, and emerging markets are backtracking. The benchmark MSCI Emerging Markets Index, which measures 21 emerging-markets country indexes, has lost 5.2% so far this year. The S&P 500, by contrast, is up 1.7% (all return figures are through March 17).

This might warn you to stay away from emerging markets, or if you’ve been investing profitably in these nations, to bring your money home. We disagree. Instead of cashing out, this is an excellent time to enter emerging markets or to increase your stake, and using exchange-traded funds is a great way to do so. The future remains bright for Asia, Eastern Europe and South America, a group of markets headed by the BRICs -- Brazil, Russia, India and China -- and also featuring such prosperous countries as South Africa, South Korea and Taiwan.

There’s no denying the present problems. A big reason for the emerging markets’ decline so far in 2011 is high inflation, fueled by record or near-record prices for oil and other basic materials, plus soaring food costs. To keep inflation from getting out of control, central banks in some developing countries have raised interest rates and may push them higher. Rising rates slow economic growth by increasing the cost of borrowing. At least one analyst fears that the emerging nations may not raise rates enough to tame rising prices. “We think the primary driver [for the stocks’ decline] is a lack of emerging-market central-bank inflation-fighting credibility in the face of mounting food-driven pricing pressure,” says Alec Young, Standard & Poor’s international stock strategist.

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Turmoil in the Middle East and North Africa and the devastating earthquake, tsunami and nuclear-power-plant crisis aren’t helping matters. Though most African and Middle Eastern countries are classified as frontier markets, which are less liquid and more lightly regulated than emerging markets, some investors worry that non-democratic countries that do have the status of emerging markets may also suffer disruptions. And the disaster in Japan has the potential of slowing growth all over the world because of disruptions in the global supply chain.

Nevertheless, the reason to invest in this group still holds: Most of the world’s growth for the next ten years will come from emerging economies. With a few exceptions, they are not drowning in debt, and they didn’t suffer badly from the credit meltdown. They have young, growing middle classes that are buying cars and houses and like to spend their newly earned discretionary income as they please. If all pans out, says Michael Gavin, Barclays Capital’s head of emerging-markets strategy, developing-markets stocks will return an annualized 10.5% through 2021. Those kinds of returns are worth shooting for.

A Broad Index ETF

To earn the return of the MSCI Emerging Markets Index, buy Vanguard MSCI Emerging Market Stock ETF (symbol VWO). You start with the advantage of the lowest expense ratio in the emerging-markets sector, 0.22%, plus you get a dividend yield of 1.8%. The top countries by weighting are China, 17.6%; Brazil, 16.3%; South Korea, 13.7%; Taiwan, 11.2%; South Africa, the only African country in the index, 7.5%; Russia, 7.4%; and India, 7.2%. The fund is down 5.2% this year, but has returned an annualized 43.8% over the last two years, and 12.7% annualized since its creation in 2005.

This ETF doesn’t carry the risks that a manager may pick the wrong stocks or the wrong countries. The drawback is that because it invests only in large and mega-size companies, many of which do big business in the U.S. and Europe, you aren’t making a pure and direct investment in the growth of emerging nations. But so far that hasn’t been much of a drag on results.

Dividends from Emerging Markets

A worthwhile alternative to the Vanguard ETF is WisdomTree Emerging Markets Equity Income Fund (DEM). This ETF emphasizes dividends, a strategy that is paying off in emerging markets as well as in the U.S. Over the past two years, this ETF returned 42.8% annualized, just below the MSCI benchmark by an average of 2.7 percentage points per year. So far in 2011, the fund, which yields 3.7%, is down 3.9%. WisdomTree’s strategy is to own the 300 highest-yielding out of the 1,000 stocks in the WisdomTree Emerging Markets Dividend index. The fund has a presence in 19 countries, with Taiwan and Brazil combined accounting for 37% of the fund’s assets. The expense ratio is 0.63%.

There’s also the WisdomTree Emerging Markets SmallCap Dividend Fund (DGS). This is the best-performing emerging-market ETF over the past two years, with an annualized return of 50.8%. The ETF holds 460 stocks, with about half of its assets in South Africa, South Korea, Taiwan and Thailand. It yields 3.0%. In this fund, you invest more directly in the local industrial and consumer sectors because you avoid giant multinational companies. It would be nice if you could have more than the 7% of the fund’s assets in Chinese and Indian stocks, but few small companies in those countries pay dividends. Expenses are 0.63%.

Target Regions

ETFs that invest in a single developing nation often don’t make sense because there aren’t enough companies for the fund to be diversified. But there will be times when several smaller emerging markets in the same region boom, generating big gains for a regional ETF. The SPDR S&P Emerging Asia Pacific ETF (GMF) gives China a 37% weighting, with Taiwan and India making up another 46%. Although that leaves little left for some countries that benefit from China’s growth, such as Malaysia, Indonesia, Thailand and the Philippines, you get more weight in those places than you would in a diversified emerging-markets fund. The fund holds 260 stocks and yields 2.2%. The management fee is 0.59%. It’s down 6.0% in 2011 and returned an annualized 42.4% the past two years.

The iShares S&P Latin America 40 Index Fund (ILF) invests in 40 large Latin American companies and gets you a 2.3% dividend yield. This is mostly a bet on Brazil, whose firms are 59% of the portfolio, and Mexico, with 23%. Most of the rest is in Chile and Peru, which are both doing well. The two-year annualized return is 43.0%; so far in 2011, it’s down 7%. Expenses are 0.5%.

Contributing Editor, Kiplinger's Personal Finance