5 ways to target emerging markets using ETFs

Investors poured $5 billion into emerging markets equity exchanged-traded funds in April, and through May 22 added another $1.5 billion to broad emerging markets ETFs, according to ETF.com data. Including more niche emerging markets offerings, the inflows have surpassed $2 billion in May. That's a big change from the $12 billion of outflows from emerging markets ETFs in the first quarter.

What's behind the reversal of fortune in ETFs? In some ways, that's less important than making sure you understand the increasing number of choices available to investors who believe emerging markets have an ongoing role in the investment portfolio.

Let's review the potential appeal as well as the various choices investors have made when it comes to emerging markets ETFs, which differ on many factors beyond just expenses.

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Year to date through May 21, the MSCI Emerging Markets Index rose 2.9 percent, outperforming the MSCI EAFE Index's 0.5 percent gain. This relative strength might be a bit of catch-up. In 2013 the advanced international markets rose 19.4 percent, much stronger than the 5.0 percent loss for the emerging markets.

The consensus is that emerging markets continue to grow more rapidly than the developed countries. According to the International Monetary Fund's April 2014 forecast, advanced markets—a group that includes the United States, Japan and most of Europe—are expected to generate GDP growth of 2.2 percent and 2.3 percent in 2014 and 2015, respectively, slower than emerging and developing economies' growth forecast of 4.9 percent and 5.3 percent, respectively.

The two largest emerging markets ETFs are Vanguard FTSE Emerging Markets (VWO) and iShares MSCI Emerging Markets (EEM), though there are notable differences when it comes to costs and holdings. VWO has a lower expense ratio, at 0.15 percent, vs. 0.67 percent, which helps to partially explain why it has appealed to many investors who were seeking exposure to the broad-based MSCI index. It also helps explain why iShares launched its iShares Core series MSCI Emerging Markets Investable Markets Index with an expense ratio of 0.18 percent.

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Top Emerging Market ETF Gainers in May ($M)

EEM iShares MSCI Emerging Markets BlackRock 861.62
IEMG iShares Core MSCI Emerging Markets BlackRock 365.90
VWO Vanguard FTSE Emerging Markets Vanguard 153.56
ILF iShares Latin America 40 BlackRock 145.74
EPI WisdomTree India Earnings WisdomTree 123.92
INDA iShares MSCI India BlackRock 116.66
RSX Market Vectors Russia Van Eck 78.71
SCIF Market Vectors India Small-Cap Van Eck 67.11
SCHE Schwab Emerging Markets Equity Charles Schwab 52.82
ERUS iShares MSCI Russia Capped BlackRock 51.61
Source: ETF.com, through May 22

The differences are bigger than just a race to the bottom in fees.

Here are five ways to dig deeper into the choices within the ETF universe that target emerging markets opportunities.

1. Know your 'Korean war' history.
Last June, Vanguard transitioned away from the MSCI index standard to a FTSE benchmark for this ETF. That move eliminated exposure to South Korea, as FTSE considers it to be an advanced market rather than an emerging one. South Korean stocks, including Samsung Electronics, made up 15 percent of EEM assets, making it the second-largest country exposure behind China. The absence of South Korea is noticeable. Meanwhile, VWO has more exposure to Taiwan, Brazil and India than EEM.

These index component changes showed up in a significant way in performance divergence. In 2013 EEM lost only 3.7 percent, while even with a lower expense ratio, VWO declined 4.9 percent. That has reversed in 2014, during which VWO has been the stronger performer, with a 4 percent return through May 22 versus a 3 percent return for EEM.

2. Swap EEM out for IEMG.
Investors should go beyond the two largest emerging markets ETFs. In fact, iShares introduction of the Core series emerging markets option compels an investor to take a look at the new but fast-growing lower-expense ETF within the same iShares family.

The iShares Core Emerging Markets (IEMG) came to market in October 2012 and has already gathered more than $4 billion in assets. Relative to EEM, IEMG has the lower net expense ratio of 0.18 percent alluded to above, but it also has additional exposure to small- and mid-cap stocks that are more tied to the local economies, including South Korea. IEMG's weighted average market cap is $38 billion, modestly below EEM's $44 billion, according to S&P Capital IQ.

In May, EEM has continued to lead the way, raking in $861 million in assets through May 22. But IEMG is second among all emerging markets funds, taking in $366 million, according to ETF.com data.

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3. Stay small.
There are many other ETFs that focus on one slice of the emerging markets investment spectrum, but there's added risk, as they offer less diversification.

For investors that want to avoid the large-caps inside IEMG, the SPDR S&P Emerging Markets Small Cap (EWX) is one such ETF, with a 0.65 percent net expense ratio. EWX's weighted average market capitalization is $1.3 billion, and its exposure to Taiwan (30 percent of assets) is much higher than the previously mentioned ETFs; India follows with 10.8 percent of assets.

4. Leave LatAm.
Of course, if you want to increase your exposure to Emerging Asia, you might want to consider SPDR S&P Emerging Asia Pacific (GMF), which has a 0.59 percent expense ratio. This regional ETF focused on some of the fastest-growing emerging markets and eliminates Latin American exposure. This is a good thing when those markets are out of favor, but owning it thus far in 2014 would have caused you to miss out on the strong gains in Brazil.

5. Invest for love of country.
There's a good chance there's at least one or more choices if you want to dig deeper into one emerging market country.

If you are looking to increase your exposure to Brazil, iShares MSCI Brazil (EWZ) is the largest, but EGShares and Global X also offer more sector-focused products such EGShares Brazil Infrastructure (BRXX) and Global X Brazil Financials (BRAF). These ETFs have 0.85 percent and 0.77 percent expense ratios, respectively.

For Taiwan, you can consider iShares MSCI Taiwan (EWT), though be mindful that it has more than 50 percent of its assets in the information technology sector.

As with any ETF investment style, S&P Capital IQ believes investors need to look closely at what's inside before investing. The emerging markets arena offers a combination of risks and rewards that need to be fully understood.

By Todd Rosenbluth, director of ETF Research at S&P Capital IQ. Follow Todd @ToddSPCAPIQ