Last updated August 23rd, 2018.
There’s a lot of investors who buy shares in an emerging markets ETF and falsely believe they’ve diversified globally.
I can’t count the number of times my clients have told me that they are, in fact, already investing in fast growing economies because they bought into some mass market ETF or mutual fund from Vanguard or iShares.
Don’t get me wrong. I’m not telling you that these ETFs won’t go up in value over time. I’m not even saying you shouldn’t buy them. But I’d like to address a common error I feel many people make when investing overseas.
Most investors buy shares in an emerging markets ETF, or a similar mutual fund, for two reasons.
First is to diversify their portfolio. By investing in different economies and currencies, you reduce your risk by not having to rely on the performance of a single market or currency.
The second reason is to achieve higher returns. Emerging markets are called such for a reason. They typically grow faster versus developed economies, are coming into their own, and are, well… emerging.
Here’s the problem: your typical emerging markets fund which your brokerage tries to sell you does neither of these things. They don’t invest in emerging markets the right way.
You Aren’t Even Investing in Emerging Markets
A large percentage of stocks owned by emerging market ETFs and mutual funds aren’t even from emerging markets. You read that correctly.
Just look below at the holdings of the iShares MSCI Emerging Markets ETF. This is the largest Emerging Market ETF on the planet with over US$31 billion dollars under management. Two of the top three countries they invest in are from South Korea and Taiwan, accounting for over a quarter of the fund’s assets.
By any measure, South Korea and Taiwan are developed nations and each have a GDP per capita exceeding that of New Zealand, Israel, and Italy’s.
Other funds, such as Vanguard’s FTSE Emerging Markets ETF, don’t do much better. They’re big fans of Taiwan for some reason. Even more bizarre is that they have exposure to the United Arab Emirates and Qatar – two of the richest nations on the planet.
You Don’t Really Want to Invest in an Emerging Market
There’s something to be said for denominating your assets into different currencies. Just ask the British who saw their net worth, in terms of many other currencies, fall by around 20% because of Brexit’s impact on the Pound.
Most emerging markets ETFs and mutual funds can help you invest in other currencies. But they fall short when it comes to avoiding financial crises altogether. Most emerging economies fared even worse than the United States during the 2008 Global Recession.
Why? Although they’re different countries with different economies and currencies, they’re highly dependent on other nations for growth.
Our world is now interconnected. 7-Eleven and Starbucks can be found in almost every corner of the globe. This means that most emerging markets rely on continued investment from businesses like these to fuel their own growth.
But when the US, EU, or China enters a recession, the investment from large multinationals stops flowing in. The result is that emerging markets also enter a decline – sometimes an even worse one.
If you truly want to grow and preserve your wealth, you might want to invest in frontier markets. These rapidly growing countries have a history of skipping global crises altogether. Cambodia, for example, hasn’t had a recession in over two decades. Other frontier markets like Mongolia and Kenya boast similar performances.
These places don’t need to worry about McDonald’s cutting back on expansion because they don’t have McDonald’s yet. But when they inevitably arrive, the extra investment will boost the growth of these frontier markets even more.
Buying into an emerging markets ETF won’t help you avoid a recession. Frontier markets, along with several other types of assets, can though.
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