Last updated November 5th, 2019.
There are lots of investors who buy shares in an emerging markets ETF and incorrectly believe they’ve diversified internationally.
Countless times, a client has told me they’re “already investing in emerging markets!” 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.
See, most investors purchase shares in an emerging markets ETF, or a similar mutual fund, for two reasons. The main reason why people invest in emerging markets is often to diversify their portfolio.
Buying property and stocks in different countries reduces your risk. After all, not having to rely on the performance of a single market or currency substantially limits your portfolio’s overall downside.
The second goal most investors have is achieving higher returns. Emerging markets are called such for a reason – they’re normally growing faster compared with developed economies, and are well… emerging.
Here’s the issue though: a typical emerging markets fund that your brokerage tries selling you won’t accomplish either of those things.
Quite frankly, you are not investing in emerging markets correctly if you’re doing so through an ETF or mutual fund. Here’s why these funds 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 funds aren’t even located in emerging markets.
You read that right: emerging markets funds don’t even invest in their namesake. At least, not nearly as much as they should.
Simply 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$30 billion dollars under management.
However, two out of the top three nations they invest in are South Korea and Taiwan, together which account for more than 25% of the fund’s total assets.
South Korea and Taiwan are developed nations by any possible metric. Each of them boasts a GDP per capita exceeding that of New Zealand, Israel, or Italy’s.
Rather an “Emerging Markets ETF”, this fund should probably be called a “China and Developed Asia ETF”. Since half its holdings are from China, South Korea, and Taiwan.
Other funds, such as Vanguard’s FTSE Emerging Markets ETF, don’t fare much better. They are big fans of Taiwan for some reason.
Yet more bizarre is that this fund has exposure to the United Arab Emirates and Qatar – two of the richest nations on the whole planet.
You Don’t Truly Want to Invest in Emerging Markets
There’s something positive to be said about spreading your portfolio across several currencies.
Merely ask anyone holding British Pounds who saw their net worth, in terms of most other top global currencies, decline by around 20% because of Brexit’s impact.
While emerging market ETFs and mutual funds can indeed help you invest in other currencies, they fall short when it comes to avoiding financial crises altogether.
In fact, most emerging economies fared even worse than the United States and Europe during the 2008 Global Recession.
Why is that? Although emerging market economies are fundamentally different from those in the developed world, they’re still dependent on wealthier nations for growth.
Our planet is now interconnected. 7-Eleven and Starbucks can be found in almost every corner of the globe. Therefore, emerging economies rely on continued investment from multinational firms to fuel their own growth.
But when the US, EU, or China enters a recession, investment from large multinationals stops flowing in. The result is that emerging markets also enter a decline – sometimes an even worse one compared with developed markets.
Frontier Markets Might Be Your Answer
If you truly want to grow and preserve your wealth, you may want to invest in frontier markets. Such rapidly growing countries have a history of skipping global crises altogether.
Cambodia, for example, hasn’t gone through a recession in over three decades. Other frontier markets like Mongolia and Kenya enjoy a similar performance.
These places don’t need to worry about McDonald’s cutting back on expansion since they don’t even have McDonald’s. When they inevitably arrive, the extra investment will surely boost their economic growth even further though.
Buying shares of an emerging market ETF won’t help you avoid recession. Yet frontier markets can, along with several more unique types of assets.
Skip the Next Western Recession
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