Few weeks ago, I posted an article earlier which discussed why emerging markets (e.g. BRIC) cannot be clubbed together. There are so many significant differences that it makes sense to look at it individually. Most likely it will also provide maximum possible return for our invested dollars. While China continues to receive most attention in the press, I believe its India that provides a much better option for small individual investors. Following are three reasons I believe India has relatively more fundamental strength than other countries.

• Inward Consumption Based Growth: India’s economy is consumption oriented when compared to other emerging markets. India’s export contributes less than 15% to its $1.2T GDP. The IT outsourcing services and back office has garnered most of the business media coverage; however, these industries have less than 8% contribution to the GDP and employ less than 5 million people. This is an indicator of growth by internal production and consumption. It is less reliant on exports. Quite contrarily, these technology services perform better in recession, because it is all about optimizing operational cost. In addition, its reserve bank (a.ka. central bank) has very conservative monetary policy, which is why we did not see failure of the banks (or banking system) during the current financial melt down. There were no widespread bank bailouts.

• Transparency: It has democratic governance which on many occasions slows down the decision making progress, but provides better transparency (relative to Russia and China). As of today, its currency is freely convertible for trading goods and services, but there are certain restrictions for international asset acquisition. However, it has a pragmatic roadmap to allow its currency to fully float with market dynamics. It has demonstrated international policy of non-confrontation which, to certain extent, immunes its economy from international squabbles.

• Government Stimulus Driven Growth is Less: The Indian market has rebounded in line with other emerging markets like China or Brazil. While it remains to be seen whether it can be sustained, the indicators suggests it may not hit similar level of bottoms again. A recent article showed rebound of earnings for companies in its SENSEX index. The key in this rebound is; not much is being supported by government driven expenditure or public infrastructure projects. In fact, it continues to stumble on its infrastructure.

Finally, India can boast that its government is run by a bunch of prominent economists (with political and public support). The architect of Indian economic reforms, who laid down the path for reforms 18 years ago, is now at its helm as a prime minister. It is always good to have a non-political leader who is not only an economist, but someone who knows how to execute it in the complex state like India. Therefore, I continue to believe that on long 10+ year time horizons my dollars are “relatively” safer in India markets than any other emerging markets. I do not expect to be a smooth ride. There will be time period when markets will crash, but it will eventually come out stronger.

Having said that, I believe, individual investors should use ETF based investment vehicles for India (or any other emerging markets) which invest in array of companies and have less fees and commissions. Keeping with this thought process, I use Wisdom Tree India based ETF, EPI. You may read more about my reasons for selecting EPI for this objective.

As individual investors, we are always careful of what we invest in and what investing vehicle we use. We try to filter the business media noise or recommendations from analyst or fund house marketing data. In last few years, we have been told that the simple and easiest way to invest in new growing emerging markets is use emerging market ETFs and/or funds. There are so many different funds with so many different themes that we should understand whether we are really getting what we are looking for. Following are few examples as observations on structures of ETFs.

Example 1: VWO and EEM are funds based on MSCI emerging market select index which is market capitalization based index. It includes 18 to 20 emerging economies where stocks can be bought free of any restrictions.

• VWO has 60% of assets invested in 130 stocks (all in native countries), while EEM’s 60% assets are in only 42 corporations (approximately 29 in ADR/GDRs).
• VWO is invested in 784 stocks with expense ratio of 0.24%, while EEM is invested in only 342 securities with expense ratio of 0.72%.
• If both are based on same index, why are these funds so different? EEM goes the easy route of investing in ADRs/GDRs, less number of corporations, and still has three times the expenses?

Example 2: BIK is fund for BRIC markets. BIK is invested in only 40 companies distributed in four countries. Of which 54% of its assets are in only 10 companies. The fund still has an expense ratio of 0.4%. Emerging economies has combined GDP of about USD 10trillion or more, and this fund picks only 40 companies to represent this. Does that make sense?

Example 3: BKF is market capitalization based index fund designed to follow MSCI’s BRIC Index. It is designed to focus only on four BRIC countries.

• BKF is invested 176 corporations out of which 34 are in the form of ADR/GDR.
• Approximately 60% of its assets are invested in only 23 corporations. With such a high concentrated position in only four countries and 23 corporations, I do not understand the rationale for expense ratio of 0.72%.

Example 4: Four funds IIF, IFN, PIN, INP, and EPI have somewhat similar objective to track performance of Indian Corporations. Each has a different method on how they execute it.

• Funds expenses are IIF (1.40%), IFN (1.18%), INP (0.89%), EPI (0.88%), and PIN (0.78%).
• Funds IIF, INP, and PIN have more than 50% investments in top 10, IFN is close of 50%. The fund with highest expenses, i.e. IIF, has approx. 62% invested in top 10. Fund EPI has 46% invested in top 10, with almost 17% allocation to just one corporation.
• After such a high fees and varied executions methods, these funds could find only seven specific corporations (in 4 funds or more), four corporations (in 2 or more), only 10 corporations (in one fund only). To put this into perspective, on India’s Bombay Stock Exchange, there were 7500 listed equities (in 2006), 7706 equities (in 2007), 7821 equities (in 2008), and 7784 equities (in 2009). The exchange’s index, known as SENSEX, itself has 30 companies on its roll. In short, with all the expertise these funds have, they could only find 21 companies of which more than 10 are common occurrences.

A general observation here is we need to really understand what we are buying. These examples show that every fund is not what we think they are.

Almost all do-it-yourself investors who are reading about emerging markets would be aware of BRIC acronym. BRIC stands for Brazil, Russia, India, and China. This BRIC label clubs four distinct emerging markets into a single entity. Based on this labeling, there are many different mutual funds, closed-end funds, and ETFs. What is ironical is there is no similarity except that they are supposed to be the new growing economies. Each of these countries have different governance structure, different governance policies, different types of economies, different strengths, different financial markets, different values, etc., Even with these differences they are clubbed together and viewed as single entity for investing in emerging markets. This is again one of the follies of Wall Street investment firms (think GS!). To top it off GS and other investment firms seems to have more lenient bent towards China’s market among the BRICs. Is this because these firms get more business in China? I am not sure if there is an open answer to this one. But clubbing all these countries under BRIC acronym does not make sense to me.Russia and China seem to have similar ambitions of having a dominant say in world affair, be militarily or economically. However, both seem to be following different paths to reach there. Russia wants to go military way using its natural resources (particularly oil), with scant regards for well being of its population. How about Russian democracy? We all know its democratic governance (pun intended)! Without oil, its economy seems to flatter. China seems to be attempting the path of economic leverage to have its dominating standing in world affairs. It is happy engineering numbers for its advantage. Democracy in China is non-existence. Ironically, we in US want to establish democracy in Arab countries, but happily gloss over at China’s democratic record. China’s export oriented manufacturing economy is quite different than Russia’s oil economy. China’s cheap exports contribute one third to its $4T GDP, while Russia’s exports contribute to one fourth to its $2T GDP. Can Russia and China be clubbed? Are their financial markets open enough for investors?

On the other hand, Brazil and India does not seem to aspire for dominance in world affairs. Both of these countries are perhaps only looking for recognition and say in world affairs. Brazil economy seems to be driven by natural resources, demographics, and internal consumption. Similarly, Indian economy is driven by its demographics and internal consumption. Brazil’s export contribution is less than 10% to its $2T GDP, while India’s export contributes less than 15% to its $1.2T GDP. Furthermore, Brazil and India follow a democratic governance which on many occasions slows down decision making, but provides better transparency to some extent (relative to Russia and China). Which one would you choose; uncertainty of bad or good in China/Russia and knowing how to manage risk; or knowing bad habits of Brazil/India and entering with risk management?

As you can see, there are fundamentally significant differences in BRIC nations. According to me there is no way one can club these countries together. This is once again a delusional concept purported by financial firms to sell their fund-based products. This BRIC label does not have any fundamental basis other than emerging markets. There are thousands of companies in all four economies, and clubbing all together to preparing a representative fund of few tens, or few hundreds does not make sense to me. Also, the idea that one can capture and hedge by investing in BRIC based funds is something that I cannot understand.

Investors interested in emerging markets should be: (a) looking at countries on individual basis; (b) using ETF based investment vehicles; and (c) maintaining allocation according to risk appetite. On a personal front, I am interested in Indian markets for its sustainability and hence use wisdom tree’s EPI as an investment vehicle. In addition, my maximum target allocation for emerging markets is 8% or less.

In my earlier post, I provided a shortlist of candidates for index-based exchange traded funds to capture the general market performance of emerging markets. These ETF-based funds are VWO, EEM, DEM, BKF, and BIK. While the shortlist provided a good starting point, in this post I am reviewing the suitability of these funds against the investment objective. The investment objective is to capture the general performance of emerging markets. I did not consider reviewing BIK, since it was invested only in 40 corporations in Brazil, China, Russia, and India.

Review of ETF Structure

Table 1, Table 2, and Table 3 provides the quantitative summary of the structure of all four funds.

Funds VWO and EEM are based on MSCI Emerging Markets Select Index which is market capitalization based index. It is invested in 18 to 20 emerging countries where stocks can be bought free of any restrictions.

• VWO and EEM follow the same MSCI index hence, almost 60% of the both funds assets are invested in five countries (Brazil, South Korea, China, Taiwan, and South Africa).
• VWO’s 60% assets are invested in 130 corporations of which none seems to be in ADR/GDRs. While EEM’s 60% assets are invested in only 42 corporations of which 29 stocks are in the form of ADR/GDRs.
• As the table shows, VWO is invested in 784 stocks with expense ratio of 0.24%, while EEM is invested in only 342 securities with expense ratio of 0.72%.
• Close of 20% of both fund’s assets are invested in financial sector.
• What I find intriguing is why these funds are different in structure when they are based on same index. EEM is investing most its assets in ADR/GDR (not native corporation’s country), less number of corporations, and still has three times the expense ratio than VWO. We will analyze if market performance justifies this higher expenses.

DEM is not a pure index fund in a sense that it does not follow any generally accepted market capitalization based indexing. It is an index which is based on fundamentals and corporations which pay cash dividends. At the index measurement date, companies within this index are ranked by dividend yield. Securities ranking in the highest 30% by dividend yield are selected for inclusion. Companies are weighted in the Index based on annual cash dividends paid.

• DEM is invested in 18 emerging countries and 296 corporations, and has an expense ratio of 0.62%.
• Approximately 60% of its assets are invested 43 corporations in five countries (Taiwan, South Africa, Malaysia, and Taiwan). While the asset concentration is similar to VWO and EEM, the countries are different. Almost 30% of DEM assets are concentrated in Taiwan alone.
• DEM seems to be investing in corporation’s native country with only two or three stocks in the form of ADR/GDR.
• Approximately 20% of the fund is concentrated in financial sector

BKF is market capitalization based index fund designed to follow MSCI’s BRIC Index. It is designed to focus only on four BRIC countries.

• BKF is invested 176 corporations out of which 34 are in the form of ADR/GDR.
• Approximately 60% of its assets are invested in only 23 corporations. With such a high concentrated position in only four countries and 23 corporations, I do not understand the rationale for expense ratio of 0.72%.
• Although the fund is focused on four large emerging markets, it has invested only 60% of its assets in only 23 corporations.
• Approximately 23% of fund assets are in financial sector.

Table 1: General Information

Table2: Country Allocation

Table 3: Industry Sector Allocation

Market Performance (See Chart)

Knowing how these four funds are structured, the next step is to look at the market performance of these four funds.

• VWO and EEM were introduced in early 2005. The chart shows very similar performance since March 2005. In fact both funds are almost tracking each other. Interestingly, both funds are almost at the same level relatively to their point of introduction in 2005.
• DEM and BKF were introduced mid-to-late 2008. Therefore, it would be prudent to look at relative performance from that point onwards. The second chart shows this relative comparison since middle of 2007. DEM is down by 43%, EEM is down 51%, VWO is down 56%, and BKF is down 59%.
• Table 1 shows VWO and EEM have higher asset base and relatively higher trading volume. While DEM and BKF have very low asset base and lower trading volume.
• Table 1 also shows that VWO, EEM, and BKF have higher volatility (Beta approximately 1.4). On relative basis, DEM has lower volatility (Beta is 1.24).

Relative Performance (VWO, EEM)

Relative Performance (VWO, EEM, DEM, BKF)

Summarizing…

So far we have looked at the structure of these funds and their relative market performance in last few years. The next step is to interpret these funds vis-à-vis the objective of investments.

• Looking at this relative comparison from a narrow viewpoint, our natural instinct will tell us that DEM’s performance is much better, followed by EEM, and then VWO.
• BKF does not seem to justify the high expense when it is under performing, investing in most of its assets only in 23 corporations, and has a very low trade volumes.
• The financial cycle and/or dividend declaration of majority of corporations in emerging market is not yet complete for year 2008. Investors will need to watch how this changes with declaration of 2008 financial results sometime by April or June 2009. In addition, investors need to realize that DEM has 30% of its asset invested in Taiwan alone. It adds to the risk factors. In addition, DEM is also not a typical dividend based investment that provides regular dividend income. The notion here is that corporations paying cash dividends are fundamentally strong and will have better performance. The dividend paid by DEM is more or less similar to VWO and EEM. Having said that, DEM is a good fit for investors looking at taking relative higher risk in order to beat the general market index.
• DEM has a potential to be a long term investment in emerging markets. At this point in time, investors should continue to watch DEM and see how it evolves with changing economic environment in emerging markets.
• VWO and EEM are two funds which have good coverage of emerging markets and have similar performance since 2005. Although their structure is little bit different, EEM is able to achieve performance similar to VWO.

In Conclusion…

VWO with its low expense ratio (and similar performance to EEM) is a good fit for investors who are looking to capture the general market performance of emerging markets. It is also trading at price levels that are similar to its introduction price point in 2005.

At the time of this writing, no position in any of above funds. I may initiate a long position in VWO in next few days.