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.

In the context of dividend investing, I believe any effect of change in dollar value will be much more profound and will affect the real total return. Dividend investors need to look at the macro economic scenario and understand how it will play out in long haul over a period of next 10 years, 20 years, or 30 years. There are folks on both sides of the aisle who make compelling argument. On one side of the aisle the argument centers on supply and demand. The flooding of printed dollar into the market will cause inflation and hence reduce its value. On other side of the aisle, the argument is that governments of many other countries are doing same for their currency. Therefore, the net affect will be practically zero. There is also another argument that printed dollar will only offset trillions of dollar lost in markets in 2008, and hence it is not likely to affect inflation. Although, I think trillions of dollars lost in market were paper money (not physical dollar), while the dollar is being pumped into the economy is physical money.

In these arguments, what do we individual investors do? Which side do we take? Or does it even really matter to take sides? Unlike physicist and engineers, economists cannot predict or control what will happen to economy. Economist can only justify afterwards why things happened that way (rather than what will happen). Honestly, I do not think anybody knows how economies will evolve. Being a dividend investor one does not need to take any sides (pun intended!). All we need to do is go back to basics. Dividends come from earnings and cash flows. Look for dividend companies that get its earnings and cash flow from global operation. This is the best hedge against dollar value.

I continue to believe there are (and will be) quite a large number of US and other multinational corporations that will profit from global operations. List below are companies that generate their revenue (and hence earnings) from all types of economies. Most of these corporations have paid growing dividends in last five years as measured in their native currency. Figures in bracket indicate approximate percentage revenue from emerging markets.

• Procter and Gamble (33%)
• Unilever (33%)
• The Coca Cola Company (approx. 60%)
• Pepsico Inc. (approx. 50%)
• Cadbury PLC (20%)
• Nestle (25%)
• Johnson and Johnson (58%)
• Qualcomm Inc (61%)
• Intel Corporation (52%)
• International Business Machines (46%)
• Exxon Mobil Corporation (60%)

Summary is…
Investing is simple if we go back to basics. Invest in dividend growth companies that have notable presence in all markets. Dividend investors continue to have array of companies which can be used as a hedge against dollar value reduction. After that, the discussion of dollar devaluation becomes inconsequential.

This article was originally published on The DIV-Net, on August 27, 2009.

TIP Guy at TIPBlog.in presented his thoughts on how dividends are perceived at least in India’s corporate world. I am reproducing certain snippets (with author’s permission).

The lack of consistent dividend growth companies in emerging markets can be interpreted in different ways

1. Emerging economies need very dollar to invest back in their businesses. The cost of external capital is typically higher, and hence it is advisable to use internal resources. Shareholders can get their return by capital appreciation on their share values.
2. The managements are not mature enough to understand the importance of common shareholders, or sharing a piece of profits with shareholders, and/or prudent cash management over longer term.
3. The taxation policies which do not favor dividend distributions.

I believe most of the corporations in emerging markets are personality driven, and lack any institutional management philosophy. The corporations are primarily driven by personal aspirations (both, good and bad), and as a result the shareholders have miniscule holdings (and contributions). I cannot recall any instance where majority shareholders (other than family and friends) or banking institutions that have been able to make any change. And hence, this has a part in driving the dividend strategies. Common shareholders have such a small percentage holdings that they always remain in back burner.

There are approximately 400 companies in India that have at least paid dividends for last 10 years. However, they have not been growing consistently. Furthermore, the dividend strategies also hinge upon governments taxation policy and cost of available capital. I believe as that as Indian economy grows and competition increases, the cost of capital will come down, and taxation policy will evolve slowly towards friendlier dividends. As of today, at least the dividends are tax free for individuals.

Certainly, there are issues about Indian corporate’s dividend friendliness. However, there are 400 companies that still pay dividends. If we look back 30 or 40 years, I tend to believe that’s how US companies and corporate may have viewed the dividends. As US economy matured, few selected companies continued to follow their strategy resulting in Aristocrats’ and Achievers. While I tend to agree that, over time, Indian corporate may evolve towards dividend friendliness, I do not think it is at a point where they can be attractive on its own. There is promise, but not yet.

Until then I believe using US-based multinationals that generate revenue from emerging markets are best proxy for investing in emerging markets. Some examples are:

• QCOM (my analysis)
• BDK (my analysis)
• CBY (my analysis)
• INTC (my analysis)
• ADM (my analysis)
• PG
• UL/UN
• Nestle

What investment vehicles do you use for investing in emerging markets?

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.