Have Emerging Markets Regained Their Mojo?

The regional emerging market ETFs are designed to follow stocks in specific geographic regions of the world. In diversification terms, these types of funds fall right between broad and single country funds.

With around $700 million in assets, the iShares Latin America 40 ETF (ILF) is one of the largest regional emerging market ETFs. ILF owns publicly traded companies in multiple countries located in Central and South America. Top countries represented inside ILF include Brazil (47.05%), Mexico (35.33%), Chile (11.55%), Peru (4.05%) and Colombia (1.78%). The advantage of ILF, like other regionally focused funds, is the ability to own a targeted geographic without taking the substantially higher risk of betting on stocks in single countries.

State Street Global Advisors offers a menu of regional ETFs targeting emerging markets in Asia (GMF), Europe (GUR), and Africa/Middle East (GAF).

Leveraged Long/Short

Tactically oriented funds that use leverage are attempting to magnify the daily performance of emerging market stocks by 200% or 300%. The bull ETFs aim for long exposure whereas the bear funds are designed for short or inverse exposure.

The Direxion Daily Emerging Markets Bull 3x Shares (EDC) is an example of a long leveraged bull fund. EDC is built to deliver triple or 300% daily exposure to the MSCI Emerging Markets Index. If the index is ahead by 1% on any given day, EDC should gain 3%. On the other hand, if the index falls 1%, EDC will be down 3%.

On the bear side, the Dierxion Daily Emerging Markets Bear 3x Shares (EDZ) aims for triple or 300% daily opposite exposure to the MSCI Emerging Markets Index. If the index is ahead by 1% on any given day, EDZ should fall 3%. On the other hand, if the index falls 1%, EDZ should gain 3%.

Since most leveraged ETFs reset their leverage on a daily basis, their performance over longer periods of time — like weeks or months or years — can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time. This effect can be amplified in markets with high volatility.

A case study by the SEC illustrates the performance extremes of leveraged long/short ETFs.

Between Dec. 1, 2008, and April 30, 2009, a particular index gained 2%. But a leveraged ETF aiming to deliver twice that index's daily return declined by 6% and an inverse ETF seeking to deliver twice the inverse of the index's daily return fell by 25%.

For this reason, the proper context for leveraged long/short emerging market ETFs — if you decide to use them — is strictly in the non-core part of a client's portfolio. Despite the negative media attention, some advisors have experienced success with these types of ETFs.

Summary

The ongoing recovery of emerging markets stocks is a positive sign. After several years of being dead money, investors who have patiently held stocks from developing countries are poised for a reward.

By using ETFs, advisors can help their clients to capitalize on the resurgence of stocks from emerging countries.

The broadly diversified funds are excellent portfolio building blocks that offer affordable and tax-efficient exposure. On the other hand, emerging market ETFs that invest in currency hedged strategies, leverage long/short, regional or single countries are best used as complementary pieces to a client's much larger core portfolio.