Be wary when buying emerging market ETFs

By Cris Sholto Heaton Feb 22, 2010

Cris Sholto Heaton

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Nanjing Road, Shanghai by night © Bartlomiej Magierowski/Shutterstock

Giant state-owned industries dominate China funds

The arrival of low-cost exchange-traded funds (ETFs) has been great for investors, particularly in developed markets. However, as I've noted before, many emerging market ETFs don't come up to scratch.

I can't do a full Asian ETF review – there are just too many out there (300-odd at my last count). And what's suitable for one investor may not be right for another. However, I do keep a list of what's available, which I'm currently updating with the latest launches. I'll include a link to this in my next article.

Meanwhile, this week, I want to look in general at some of the weaknesses of many EM ETFs, which should help you to avoid some of the poorer quality funds out there …

ETFs are great for investing in developed markets

If you buy a fund which tracks a large developed market index such as the S&P 500 or the FTSE 100, you get a reasonably well-balanced portfolio of shares across a wide range of sectors, as the chart below (for the S&P 500) shows.

Sector allocation for the iShares S&P 500 ETF

On top of that, there are few state- or family-owned companies. Cross-holdings between different firms are also limited. And in most cases, there will be a wide base of shareholders, with no one person or group in control. Management is supposed to be professional and committed to increasing shareholder value as their top priority.

Sure, this last point sometimes breaks down. The management may try to boost the share price in the short term to increase the value of their stock options at the expense of the company's long-term prospects. Or they may embark on a value-destroying takeover spree. But in principle, these firms are supposed to be run for all their shareholders.

Emerging market ETFs aren't always well balanced

In emerging markets, it can be a different story. Let's take a look at the most popular index for China ETFs – the FTSE/Xinhua 25. As you can see below, this is concentrated in a handful of sectors such as financials, telecoms and natural resources. It's not a well-balanced portfolio.

Sector allocation for the iShares FTSE/Xinhua 25 ETF

Why? Well, in emerging markets, firms in these industries tend to be the largest around. So when you're compiling an index, it ends up being heavily weighted towards them. In China's case, the giant state-owned firms that dominate these industries have a scale that no other Chinese firm can manage.

If we look at the stocks that make up this index, we see that almost all of them are ultimately government-controlled. Worse still, there aren't many companies here I'd want to buy for my portfolio. This again is different to the S&P 500 or FTSE 100, which contain a large number of high quality stocks.

Components of the FTSE/Xinhua 25 index

CompanyWeight in index
China Mobile 10%
China Construction Bank 9%
Industrial & Commercial Bank of China 8%
China Life Insurance 7%
Bank of China 6%
Bank of Communications 4%
China Citic Bank 4%
China Merchants Bank 4%
China Petroleum & Chemical Group (Sinopec) 4%
China Shenhua Energy 4%
China Telecom 4%
China Unicom 4%
CNOOC 4%
PetroChina 4%
Ping An Insurance Group 4%
BYD 3%
China Coal Energy 3%
Air China 2%
Aluminium Corporation of China (Chalco) 2%
China Communications Construction 2%
China COSCO Holdings 2%
China Railway Group 2%
Zijin Mining Group 2%
Datang International Power Generation 1%
Huaneng Power International 1%

This isn't just a problem with China. Let's take a look at India (below). The Sensex is better balanced in terms of sectors. But we're still not getting much exposure to key themes such as the emerging market consumer – just 7% is in fast-moving consumer goods (FMCG).

Sector allocation for the iShares BSE Sensex ETF

And listed companies in India aren't run like most developed market firms. Most are controlled by family-owned groups. For example, the Tata Group has four separate listed divisions in the 30-stock Sensex.

Components of the Sensex

CompanyWeight in indexControlling interest
Reliance Industries 13% Mukesh Ambani
Infosys 10% None (several founders)
ICICI Bank 8% None (Life Insurance Corp largest shareholder)
Larsen & Toubro 7% None (Life Insurance Corp largest shareholder)
ITC 6% None (British American Tobacco largest shareholder)
HDFC 5% None (Citigroup largest shareholder)
HDFC Bank 5% HDFC
State Bank of India 4% State
ONGC 4% State
Tata Consultancy Services 3% Tata Group
Bharat Heavy Electricals 3% State
Bharti Airtel 3% Sunil Bharti Mittal
Tata Steel 3% Tata Group
Sterlite Industries 2% Anil Agarwal
Hindustan Unilever 2% Unilever
NTPC 2% State
Mahindra & Mahindra 2% Mahindra Group
Tata Power 2% Tata Group
Hindalco Industries 2% Aditya Birla Group
Tata Motors 2% Tata Group
Maruti Suzuki 2% Suzuki
Wipro 2% Azim Premji
Grasim 2% Aditya Birla Group
Hero Honda 1% Honda and Munjal family
Reliance Infrastructure 1% Anil Ambani
Sun Pharmaceutical 1% Dilip Sanghvi
DLF 1% Kushal Pal Singh
Reliance Communications 1% Anil Ambani
ACC 1% Holcim and Ambuja Cements

Family-owned firms have their good points. If the company's managers are also the controlling shareholders and most of the family wealth is tied up in the firm, then they may be more inclined to take a long-term view of the business's prospects.

But a controlling shareholder can also work against the interests of minority shareholders. By using a complex corporate structure with many listed and unlisted subsidiaries, an individual or family can have complete control, despite owning a small minority of overall shares.

By shuffling assets or setting up joint ventures, they can enrich themselves at the expense of the rest of the shareholders. Many Southeast Asian tycoons have an appalling track record in this respect. And their groups often make up a significant chunk of the index.

Some emerging market ETFs are more diverse than others

So there are two potential problems with investing in emerging market ETFs. First, the companies may be poor quality. Second, you might not get access to the sectors you're really interested in, such as the emerging market consumer.

So what should you do? The ideal solution is to invest in emerging markets through a well-chosen portfolio of stocks, rather than through ETFs. That way you can alter the weightings and avoid poorer quality companies. But many investors prefer to use ETFs for simplicity and cost. If you do this, you'll have to compromise to some extent, but you can avoid some of the worst traps by being selective.

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All good ETF providers have a breakdown of the sectors and stocks that the fund invests in on their website. So it's easy to find out exactly what it's tracking before you buy it.

For example, if you just want to trade a short-term move in the Chinese market, a FTSE/Xinhua 25 tracker may well be suitable. After all, this index contains the big, high-profile Chinese stocks that will draw in most of the money when investors want to pile into China. A tracker from a big provider such as iShares, Lyxor or DB x-trackers will be relatively low-cost, liquid and have tight bid/offer spreads.

But on a very long-term view, better options may be available in the US or Hong Kong. For example, consider the SPDR S&P China. This invests in a much wider basket of stocks, including large state-owned firms and smaller ones listed in Hong Kong, the US and Singapore. As you can see below, it's still quite heavily invested in financials and energy. But there's a bit more diversity to the portfolio, with a combined 11% weighting in consumer sectors.

Sector allocation for the SPDR S&P China ETF

Other alternatives include the Claymore/Alphashares China Small Cap, which is another Hong Kong, US and Singapore-listed fund. Or the PowerShares Golden Dragon Halter USX, which invests only in US-listed stocks.

Both take the financials exposure down even further (12% and 7% respectively). The Claymore fund has minimal energy exposure as well. Most recently, new niche provider Global X has launched a number of Chinese sector ETFs, which track Hong Kong-listed stocks, including a consumer-themed one.

Always do your research before you buy

This sort of choice is relatively new for Asia ETFs. It's largely confined to China so far. Sometimes you'll find an interesting niche product in another area. As I mentioned last week, there are the iShares Far East Smallcap and Emerging Markets Smallcap funds. These have a much higher weighting in consumer sectors. Small caps are likely to be far more volatile, but they may also be innovative entrepreneurial firms that can grow into future heavyweights.

In a few cases, the regular index is better than you might expect. For example, the sole Indonesia ETF available so far, the Van Eck Market Vectors Indonesia, has around 23% in consumer stocks. While the country has some problems with the quality of its companies, the portfolio looks reasonably good.

At the other extreme, any MSCI Taiwan tracker – available from a number of providers - will be very tech heavy at around 60% of the portfolio. This is inevitably a very cyclical index, but to an extent that reflects the make-up of the Taiwanese economy. And on the positive side, this includes plenty of high quality firms, including some that are slowly building an international image, just as many Japanese and Korean manufacturers have before.

Others indices are more mixed. For example, the MSCI Malaysia index is reasonably well-balanced in terms of sectors, but there are certainly plenty of weak companies in the Malaysian market. But Malaysia is a potentially interesting market if economic reforms continue and an MSCI Malaysia ETF is one of the easiest ways to invest. It's not ideal, but I think it's worth the trade-off.

However, there are emerging market ETFs I wouldn't touch regardless of how much I liked the underlying country story. The worst offenders are generally not in Asia. One example would be any Turkey tracker. With around 60% in financials, a benchmark like this does not reflect any developing manufacturing economy well.

Overall, for those willing to shop around, the emerging markets ETF choice is becoming better. But there's a lot more room for improvement. Hopefully, we might see sector ETFs for major markets such as India and broad-based thematic ETFs based on themes such as EM consumers coming out in the future.

In the meantime, you have to be careful what you're putting your money into. Just as you shouldn't buy a managed fund without looking at the manager's track record, neither should you buy an ETF on the strength of its name, without checking exactly what it invests in.

• This article is from MoneyWeek Asia, a FREE weekly email of investment ideas and news every Monday from MoneyWeek magazine, covering the world's fastest-developing and most exciting region. Sign up to MoneyWeek Asia here

Comments (7)

Published in Stock markets | More articles by Cris Sholto Heaton

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  • 1. John

    (22 February 2010, 11:40PM)  Complain about this comment

    Dear Cris

    I thought your article on emerging markets ETF's was excellent. You have obviously studied this subject and have a good understanding of what to be aware of - congratulations.

    I am just about to invest in emerging market ETF's so your article was timely. May I ask if you could recommend a site / company that does the ETF research and can make recommendations as I find it highly complex and time consuming to sort them out?

    Any advice you could offer would be much appreciated. Thank you in anticipation of your reply.

    John H Stalker (Money Week Subscriber)


  • 2. Roger

    (23 February 2010, 12:55PM)  Complain about this comment

    Excellent Cris,

    Your article is so informing. I held a FTSE/Xinhua 25 index ETF and it has been a distinctive under-achiever in recent months. Now I look at the companies making the index, I understand why.

    These are large companies mature at equivalent US 1990-2000 economic levels (they are already dominant players and have taken up significant market share with little potential to expand in their main businesses). We need to buy China companies at equivalent to US 1980 levels.

    I am sure India ETFs has the same problem.

    I will sell the FTSE/Xinhua 25 index ETF asap and re-evaluate the strategy. Thanks again.

  • 3. Roger

    (23 February 2010, 12:59PM)  Complain about this comment

    Cris,

    It is clear we should avoid ETFs in emerging market cases.

    Do you have some reputable open ended funds to recommend?

  • 4. DazO

    (23 February 2010, 01:17PM)  Complain about this comment

    A good article with long term investment and good basic investment principles in mind (instead of the usual MW speculative articles), but let down with the last paragraph.
    It has been proven by numerous studies that you can not rely on managed funds past performance as a guide for future performance. This is a major reason for investing in index trackers/ETF's. MW should know this important fact.

  • 5. Cris Sholto Heaton

    (24 February 2010, 03:37PM)  Complain about this comment

    John, unfortunately there isn’t a great deal of research like that as far as I know. Morningstar, Trustnet, Hargreaves Lansdown, S&P etc all do managed fund analysis, but since the principle with ETFs is supposed to be that it’s simple and you just buy the market, there’s not a lot of comparison work out there, even though in practice all ETFs are not of equal merit.

    You could look at sites like ETFtrends.com and IndexUniverse.com (the latter is more technical), which discuss these things in detail and sometimes analyse specific ETFs. But at this stage to sort out the better ETFs, you have to dig into the detail yourself. It’s something I’m trying to work into MoneyWeek Asia more as the choice of ETFs becomes greater and I might look at having some kind of best ETFs list.

  • 6. Cris Sholto Heaton

    (24 February 2010, 03:38PM)  Complain about this comment

    Roger, with regard to China, there are the small-cap or smaller-cap biased ETFs such as the ones I mentioned which appeal to me more than the FTSE/Xinhua 25 and the choice is growing. We don’t have the same for India yet, though I’d hope it’s coming. I wouldn’t say that we have to avoid all EM ETFs, but we need to be selective.

    Re open-ended funds, the problem is that many of these are effectively trackers or high-beta trackers (ie they go up more, but come down more). On the whole, they hold the stocks as the benchmark in roughly the same weights. There are a lot of reasons for this, but one is manager survival instinct – it’s far more dangerous to your career prospects to diversify far away from the average and risk being conspicuously wrong than sticking close to it and performing like most of your peers.

  • 7. Cris Sholto Heaton

    (24 February 2010, 03:51PM)  Complain about this comment

    [continued] That’s related to DazO’s point – there’s no connection between short-term past performance of the fund and what it’s likely to do in the future, which is what people often judge funds on. When I say ‘track record’ I don’t mean the last three years’ performance but what you can learn about the manager’s approach and strategy. If I’m buying an actively-managed fund (and I generally don’t), I want to see the manager is trying to do something different, rather than sticking to the index. Whether they’ve outperformed or underperformed the index in the recent past is basically irrelevant.

    Morningstar, Trustnet etc are useful – you can screen for individual funds, read analysis, look at the largest holdings and see whether they’re exactly the same as everyone else and so on.

    There are some fund management outfits that seem to be generally better than others. Aberdeen is one and I tend to look at their funds before most.

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