S&P Likes 1 Emerging Markets ETF, Tepid on 5 Others

Well-documented have been the struggles of emerging markets equities this year relative to U.S. stocks.

Concerns about global growth, commodities demand, inflation and other issues have plagued developing stocks and, particularly at the ETF level, some of the worst laggards have also been the largest emerging markets. That roster includes the four BRIC nations along with South Korea and Taiwan.

Still, investors are putting some cash to work in emerging markets ETFs, though at a much slower clip than what was seen last year. In 2012, emerging markets ETFs and ETNs raked in $30.5 billion in capital, but that figure was just $4.6 billion in the first quarter after outflows of $4.7 billion in March alone, according to BlackRock data.

Investors are also eschewing country-specific funds in favor of diversified emerging markets ETFs, though the iShares MSCI Mexico Investable Market Index Fund (NYSE:EWW) gained $1.2 billion in inflows. Despite the struggles of the broader emerging markets group, some analysts see opportunity within the asset class.

S&P Capital IQ "believes that the expected stronger economic growth is driven by better demographic trends; lower worker to retiree ratios; a growing middle class; rapid urbanization, which fuels infrastructure spending and raw material demand; and natural resource wealth," the research firm said in a new note.

Beyond the BRIC quartet of Brazil, Russia, India and China S&P Capital IQ "advises casting a wide net to include lower-profile markets like Indonesia, Turkey and Mexico where performance has been much stronger than the BRIC markets in recent years, reflecting steadier growth, lower inflation and an uptick in investor interest."

In the note, S&P Capital IQ highlighted six diversified emerging markets ETFs, but only one earned an Overweight rating, the iShares Core MSCI Emerging Markets ETF (NYSE:IEMG). IEMG debuted last October as part of the new core series of ETFs from iShares aimed at cost-conscious investors. Rather than lower the fees on the iShares MSCI Emerging Markets Index Fund (NYSE:EEM) to be comparable to the rival Vanguard FTSE Emerging Markets ETF (NYSE:VWO), iShares created IEMG.

It is hard to argue with the success iShares has had with the new fund. In just seven months, IEMG's low expense ratio of 0.18 percent has helped the fund attracted almost $915 million in assets, according to iShares data.

IEMG is comparable to other major diversified emerging markets ETFs in that it devotes the bulk of its weight to China, South Korea, Brazil and Taiwan. Those countries combine for over 55 percent of the fund's weight. EEM also devotes over 55 percent of its weight to those countries. VWO, the largest emerging markets ETF by assets, is gently winding down its exposure to South Korea as Vanguard transitions to the FTSE Emerging Markets Index, which does not consider South Korea a developing market.

VWO and EEM, the second-largest emerging markets ETF by assets, are rated Marketweight and Underweight, respectively, by S&P Capital IQ.

S&P acknowledged some of the risks associated with investing in the developing world in the note.

"While emerging markets offer investors higher potential rewards, they come with risks," said the research firm. "Relative to the S&P 500 Index three-year standard deviation of 15, the MSCI Emerging Markets Index's standard deviation of 21 was quite high. Emerging markets have less capital market liquidity and transparency than developed markets but that that is reflected in much lower valuations than developed markets, with the MSCI EM Index trading at just 10.7X 2013 consensus estimated EPS vs. 14.2X for the S&P 500 and 12.7X for the S&P Europe 350 Index."

Investors looking to mitigate emerging markets volatility have a couple of options as the low volatility craze seen with U.S.-focused ETFs has permeated developing world funds as well. S&P has a Marketweight rating on the PowerShares S&P Emerging Markets Low Volatility Portfolio (NYSE:EELV), which debuted in January 2012 and now has nearly $131 million in AUM.

EELV tracks the S&P BMI Emerging Markets Low Volatility Index. As of February, this S&P index's standard deviation was 16, well below the MSCI Emerging Markets Index, according to S&P. EELV allocates about half of its weight to Malaysia, Taiwan and South Africa. The fund has an annual expense ratio of 0.29 percent.

Interestingly, S&P has Underweight ratings on two country-specific ETFs that have been leaders among emerging markets funds this year. The iShares MSCI Turkey Investable Market Index Fund (NYSE:TUR) is up seven percent year-to-date and was one of the top-performing emerging markets ETFs last year.

The iShares MSCI Indonesia Investable Market Index Fund (NYSE:EIDO) also earned an Underweight rating from S&P, though that ETF has surged 10.7 percent on a year-to-date basis. EIDO and rival Indonesia ETFs have been buoyed by the country's strong domestic demand story.

Indonesia, the world's fourth-largest country by population, is expected to post GDP growth this year of 6.25 percent this year, up slightly from 6.23 percent in 2012. Amid rising inflation and slack materials demand, the Jakarta Composite and EIDO will likely need strong contributions from discretionary and staples shares to continue to the upside.

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