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Shidlo: Avoid Hasty Emerging-Markets Retreat

By    |   Thursday, 10 February 2011 08:02 AM

The media coverage of violent clashes in Egypt and Tunisia has resulted in investors starting to withdraw billions of dollars from emerging-market exchange-funds (ETFs).

To put the outflows of US$4 billion to $5 billion ending the week of Feb. 2 into perspective, one must remember the huge influx of nearly $100 billion during 2010.

Is this outflow the start of a new trend or just some knee-jerk reaction? Is it time for individual investors to cash in their profits from 2010? If one invested in emerging-market index funds, one would have made double-digit profits in 2010.

Anti-Mubarak Protesters
There are several reasons why we see an outflow of funds in emerging-market stock funds. For example, the violent clashes in Tunisia and Egypt resulted in investors rethinking the political risks of investing in emerging markets.

The Egyptian stock market index dropped about 20 percent in January after rising 15 percent last year and 35 percent in 2009. Most emerging fund managers agree that Egyptian stocks are cheap although there is a good reason: reduced economic growth due to the protests and uncertainty if future governments will be investor-friendly.

What is important to remember is that not all emerging markets are equal. It is probably wise to wait and see how the situation develops in the Middle East before investing in this region. The Mideast has a very young population with a growth potential, unlike some Western economies with an aging population.

Unless the crisis in Egypt develops into a global crisis — for example, the closure of the Suez Canal which would result in a sharp increase in oil prices — one should look at this wide sell-off as an opportunity to invest in emerging economies.

Another reason that there was a sell-off in emerging stock funds is that investors, both institutional and individual, tend to sell the winners of 2010 and book profits.

Some investors think that one needs to rotate their portfolio – emerging markets that went up a lot in 2010 should be replaced, for example, by S&P 500 and European shares. Another possible explanation for the sell-off is that some investors think with food prices increasing sharply, developing countries’ growth will slow.

Consumers in BRIC countries (Brazil, Russia, India and China) are more sensitive to food prices because they spend an average of 19 percent of their income on food. In the U.S., it is only 6 percent of income. Central banks in many emerging economies already started to react to food inflation — raising interest rates and thus slowing growth.

Still, investors that haven’t benefitted from the rally in emerging economies, or have only a small portion of their portfolio in the latter, should take the opportunity of this small correction and invest in ETFs that focus on BRIC countries.

Brazil’s economy will benefit from the World FIFA Football Cup in 2014 and the Olympic Games in 2016 with huge investments in infrastructure. In addition, Brazil is a country that is benefiting from the high prices of commodities, which it exports mostly to China. Russia also benefits from the high prices of oil, gas and other commodities.

In the short term, India and China’s growth might be lower than in the past but still it will be higher than European or U.S. growth. India and China have economies with a young population that are in the process of shifting their economy from dependence mostly on exporting to the West to countries with a large domestic consumer base.

It is important to point out that not all emerging countries had an outstanding performance in the last year. Both the Brazilian stock market and the Chinese stock market had flat performances in 2010. China is now trading at below historic valuations.

For example, the iShares FTSE China 25 Index Fund (FXI) is trading at an average price/earnings of 12.80 and price/book of 1.86 while Brazil is trading at even a lower valuation - average price/earnings of 12.12 for the MSCI Brazil Index Fund (EWZ) and price/book of 1.63.

The Russian Market Vector ETF (RSX) has even lower average price/earnings of 8.45 and a price/book of 0.84. These emerging-market ETFs have cheaper valuation than the S&P 500 or the Nasdaq.

There are a wide variety of emerging-market ETFs that cover a wide variety of countries: SPDR S&P Emerging Middle East and Africa (GAF); Vanguard Emerging Markets ETF (VWO); Guggenheim Frontier Markets ETF (FRN); iShares MSCI Emerging Markets Index Fund (EEM) or ones that cover individual economies.

In addition, there are ETFs that invest in the four BRIC countries: Guggenheim BRIC (EEB); iShares MSCI BRIC Index (BKF) and SPDR S&P BRIC 40 (BIK).

Investors should look at the holdings of each ETF to see in which countries they invest in and to avoid investing in two or more funds that have similar shares.

Investors should monitor the situation closely and consider increasing their investments in emerging markets.

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The media coverage of violent clashes in Egypt and Tunisia has resulted in investors starting to withdraw billions of dollars from emerging-market exchange-funds (ETFs). To put the outflows of US$4 billion to $5 billion ending the week of Feb. 2 into perspective, one must...
Thursday, 10 February 2011 08:02 AM
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