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Are ETFs The Best Entry Into Emerging Markets?

The main point of investing in emerging markets is to capture growth, but emerging market investors may be missing out on that growth. Are ETFs a better way to invest in emerging markets?

The main point of investing in emerging markets is to capture growth. While the U.S. and Europe are stuck in low gear, boosting their GDP at a rate of roughly zero to 2 percent a year, the developing markets of the world are marching ahead at 5 percent to 7 percent or more. The great irony for emerging market investors is that they may be missing out on that very growth, says Adam Patti, the founder and CEO of IndexIQ, an ETF and mutual fund developer. Patti, who formerly led the Fortune index funds for Time Inc, says many emerging market funds are geared toward export-driven multinationals based in the U.S. and large financial and energy companies. While those strategies certainly are linked to the growth of demand for raw and finished materials in emerging markets, “they don’t necessarily capture the domestic growth in the emerging markets themselves.” With that in mind, IndexIQ, of Rye Brook, N.Y., has recently launched its Emerging Markets Mid Cap Fund, which trades under the symbol EMER. The fund is geared mostly toward mid-cap companies in economies such as South African, South Korea and Taiwan. The fund targets sectors such as the consumer market, health care and industrials, which stand to benefit directly from the growth of their domestic markets, where a new middle class is rising up. By focusing on mid-cap companies, defined as those in the 75th to 85th percentile of market cap, Patti expects to find good value, too. Mid cap stocks tend to outperform small cap stocks and large cap stocks. Emerging markets are fast eclipsing developed nations in economic importance. Morgan Stanley said earlier this year that emerging markets such as China, Brazil and India already account for 37 percent of global GDP, and that their share will rise to 49 percent in 2020 and 59 percent in 2030. For the most part, portfolios are still geared toward the not-so-distant past, when emerging markets played a small role in portfolio construction, adding a bit of growth and diversity. In those days, the rule of thumb was to allocate 5 percent to 10 percent of assets to emerging markets, Patti says. He says the allocation today should be much higher, in keeping with the role of emerging markets in global GDP. “I don’t know if I would say that 40 percent is the right allocation. But 20 percent might be a good guideline,” Patti says.

As the credit crisis crippled the U.S. and Europe, emerging markets outperformed developed markets. That shifted last fall, as the U.S. and Europe showed signs of recovery, and emerging markets such as China began to apply the breaks to control inflation. Now the recovery in the U.S. appears to be slowing once again, and Patti says a shift back toward emerging markets may be due.

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