Interactive Investor

How to invest in emerging markets using ETFs: a beginner’s guide

22nd January 2021 13:13

Tom Bailey from interactive investor

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Our ETFs editor explains what emerging markets are and how to invest in them. 

Colloquially, emerging markets is a catch-all term for countries that are less economically developed. So this can include everything from China, the world’s second-largest economy, to some of the world’s most impoverished nations.

However, when it comes to investing, definitions are a bit stricter. Generally, the poorest countries in the world are not classified as emerging markets. Instead, emerging markets are usually countries that, while still poorer per capita than much of Europe of North America, are seen as taking real strides forwards in transitioning to becoming wealthier. In addition, they are countries that are becoming more engaged with the global economy and global markets.

This means that emerging markets typically have fast economic growth rates – this is part of their appeal to investors. However, emerging markets have various risks, including currency volatility, political instability and weak institutions.

Which countries are emerging markets?

Which countries are classified as emerging markets is not universally agreed upon.

According to the index provider MSCI, the following countries are emerging markets: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, South Korea, Kuwait, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey and the United Arab Emirates.

However, FTSE-Russell, a rival index provider, has a slightly different list of countries. For example, FTSE Emerging Index classifies Romania as an emerging market, while MSCI classifies the country as a “frontier market”.

Most notably, MSCI classifies South Korea as an emerging market. FTSE-Russell does not, viewing the country as a developed market, owing to its relative level of wealth. South Korea is a big market (around 13% of the MSCI index) and so its inclusion in the index has a real impact on performance.

Commodities and oil?

It used to be the case that the emerging market index was dominated by oil and commodity exporters, and financials.

Many emerging markets, such as Brazil and Russia, are heavily reliant on the extraction and sale of oil, metals and other commodities. 

Companies in these industries are often some of the biggest listed on their stock markets. At the same time, the overall performance of these economies and other businesses is closely tied to energy and other commodity prices.

As a result, the performance of these parts of the emerging market index is very cyclical, with performance correlated with the general performance of the global economy.

Historically, China has been a key customer for commodities and, therefore, a driver for the performance of many emerging markets. This was the case in the 2000s and early 2010s when Chinese demand for commodities boomed, boosting the performance of many emerging markets. However, this may be changing.  

First, China is trying to move away from being an economy driven by investment and construction, towards a more consumer-based one. If the Chinese government is successful in this, Chinese commodity demand may be less of a driver of emerging market performance.

Second, emerging market indices are increasingly dominated by Chinese and other Asian tech companies. The largest five constituents of the MSCI Emerging Market index includes Chinese internet giants Alibaba (NYSE:BABA) and Tencent (SEHK:700), alongside Chinese food delivery company Meituan (SEHK:3690). Also in the top 10 is Chinese e-commerce giant JD.com (NASDAQ:JD).

Other emerging market tech companies are also usually found in emerging market indices. For example, the South African consumer internet company Naspers (LSE:NPSN), Korean electronics company Samsung (LSE:SMSN) and Taiwanese semi-conductor exporter Taiwan Semiconductor (NYSE:TSM).

As of 20 January 2021, the only company classified as an energy firm in the MSCI index’s top 10 weightings was Reliance Industries (LSE:RIGD), a company based in India, which is not a traditional energy or commodities exporter.

Another thing to bear in mind is that the performance of emerging markets tends to correlate with the US dollar. When the US dollar is strong, emerging markets tend to struggle. But when the US dollar is weak, this is a tailwind for emerging markets. Behind the correlation is emerging market countries having a large amount of US-denominated debt. So, when the dollar rises, servicing that debt becomes more expensive, acting as a drag on economic performance. The reverse is true, when the dollar weakens.

ETFs for accessing emerging markets

The HSBC MSCI Emerging Markets ETF GBP (LSE:HMEF) is the cheapest on interactive investor, charging 0.15%. The second cheapest is the iShares MSCI EM ETF (LSE:IEEM), which charges 0.18%.

There is also the iShares Core MSCI EM IMI ETF (LSE: EIMI), which also charges 0.18%. This ETF differs from the other iShares one in that it tracks the MSCI Emerging Markets Investable Market Index. The main difference is that the index also includes small-cap stocks, giving it just over 3,000 constituents.

As mentioned above, the FTSE Emerging Index does not include South Korea, in contrast to the MSCI Emerging Market index. The most popular ETF to track this is the Vanguard FTSE Emerg Markets ETF USD Acc GBP (LSE:VFEG).

There are also several reasonably priced ESG-screened emerging market ETFs. For example, the iShares MSCI EM IMI ESG Screened UCITS ETF (LSE: SEGM), which has an ongoing charge of 0.18%. However, it should be noted that its top 10 holdings look almost identical to the broader MSCI emerging market index, just with a slightly higher weighting, owing to the few dozen companies excluded.

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

 

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