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ETF Focus concentrates on new ETF product developments and highlights strategies to get the most out of your ETF portfolios.
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Wednesday, March 15, 2006
Emerging Market ETFs: What's Next?
Exchange-Traded Funds (ETFs) tracking emerging markets have had a remarkable run. In 2005, the South Korea (EWY) was been up 57%, Brazil (EWZ) up 56%, Mexico (EWW) up 49% and the Emerging Markets (EEM) up 34%. In the last 12 months, China (FXI) has shown some life up 26% and South Africa is up 32%.
The MSCI Emerging Market index is up 82% since mid-2004. In addition, lower risk countries like Singapore (EWS) have been up for four straight years and its Straits Times Index has risen by 85% since 2003.
I am getting a lot of call lately about what to do next. Should investors buy, hold or sell?
There are two arguments out there about the future of emerging markets at polar extremes from each other. BCA Research notes that despite the run up in prices over the past three years, trailing and forward PEs are only 13 and 11 respectively. Both are far from being out of line from both a fundamental and a historical basis. Brazil is a good example with a market at about 10 times earnings.
Morgan Stanley took a different view in a research report published last week. It points to the shrinking of the sovereign risk premium for emerging markets as a sign of potential weakness. In other words, the degree of higher interest rates demanded from the market to offset the higher risk of emerging markets has shrunk sharply. In 2004 it was 3.5% and now it is about 0.50%. There can be little doubt that this shrinkage has fueled at least part of the rise in emerging markets.
The truth probably lies in the middle of these extremes. The world is filling in and emerging markets will very likely outperform more mature markets but don't expect a straight line up. Near term there will be some pullbacks in specific countries depending on circumstances.
Be alert, get some good intelligence, and put in place some measures to control risk. Here are a few ideas.
First, follow our portfolio approach whereby we weigh each ETF in a portfolio to prevent getting carried away with too large a position in an emerging market ETF. It is a bit like dining out, you may like Thai food once in a while but do you want it every night?
Second, keep emerging market ETFs out of your core portfolio which should have the goal of preserving capital.
Third, use our trailing stop loss strategy that kicks out an ETF down 10% or so from its high.
Fourth, use put options to mitigate risk. When you buy the China ETF (FXI), consider buying a put option on this ETF out 18 months at the same time.
Fifth, if you have an emerging market ETF that has had a great run, why not take some money off the table? As old Joe Kennedy aptly put it: "only a fool holds out for top dollar."
My view is that for the most part, emerging market countries are in far better shape today than in the 1990s and valuations are not way ahead of themselves. Also some of the lower risk countries like Singapore are appealing. In the early part of 1997 before prices crashes, the Singapore Straits index was at 24 times earnings. Now it is 15 and the broader market is at 12 times earning.
Keep in mind that 200 years ago India and China made up 50% of world GDP. We have a long way to go with this story but you need a smart strategy able to weather some turbulence now and then.
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