A Solid Third-World Bet For 2013

Emerging markets should continue their standout performance in 2013, with growth expected to average 3 percent to 8 percent vs. just under 1 percent for the developed world.

The drivers for emerging markets are rising domestic consumption and favorable demographic trends, which ironically are catching a tailwind from the easy-money policies of the developed world. Inflation isn’t much of a concern yet, and more money in the system is once again driving up the prices of commodities and other real assets, helping to create wealth in resource-rich emerging markets.

Equity markets in first-world nations, such as the US and much of Europe, should perform well this year as the recovery continues. But iShares MSCI Emerging Markets Index (NYSE: EEM) gives investors access to markets that should perform even better. EEM is up about 5.9 percent annualized (in US Dollars) during the past three years, and we look for continued gains in 2013.

EEM tracks the MSCI Emerging Markets Index, which is designed to mirror the performance of the largest stocks across 21 emerging markets. EEM currently holds about 840 equities generally allocated in this way: 55 percent Asia; 22 percent Europe and 21 percent Latin America.

About 18 percent of EEM’s assets are invested in China, which is recovering from two years of slowing growth, as domestic consumption offsets the slack created by slower government spending on infrastructure. EEM also offers exposure to Brazil and Mexico 12.7 percent and 5.5 percent of assets, respectively which are benefitting from rebounding demand for commodities and are much more competitive in terms of labor costs.

In terms of sectors, financials are the most heavily represented, at around 25 percent of assets. This is largely a function of the fund’s capitalization- weighted index, since financial companies tend to be among the largest in any market. But it also allows investors to benefit from the rapid growth in the banking, insurance and investment industries in many of these countries, thanks to growing wealth.

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Energy and materials sectors make up another quarter of assets, followed by consumer names, industrial companies and the telecom, IT and utilities sectors.

EEM’s 0.69 percent annual expense ratio is in the upper range for its category, but it’s tough to beat the fund’s breadth among emerging markets.

Some caveats. The index tracked by EEM is much more volatile than the S&P 500, especially during a global downturn. In 2008, for example, EEM lost more than half its value. But investors who were able to endure such losses have been amply rewarded over the long term. EEM has gained almost 296 percent since its early 2003 inception, quadrupling the S&P 500’s return.

Also, like most foreign-investing ETFs, EEM does not hedge its foreign- currency exposure, so a rising US dollar will weigh on its returns. However, we think emerging market currencies are unlikely to depreciate relative to the dollar in the next year.

A more pressing issue: MSCI Barra, the provider of the MSCI Emerging Markets Index, is expected to decide in 2013 whether it will upgrade South Korea and Taiwan to developed-market status. These two countries now account for some 25 percent of EEM’s allocation. So EEM’s profile could change significantly, especially when it come to the fund’s tech holdings, which are heavily weighted toward Korea and Taiwan.

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