New ETF Offers Direct Exposure to Emerging Markets

• Manufacture as cheaply as possible by keeping your currency weak
  
  
• Ship it all to the United States and Europe

This was a wildly successful strategy -- so long as the Westerners were buying. Following Japan, it's what allowed Taiwan and South Korea to enjoy European levels of development and China to quickly jump from being one of the poorest countries in the world to be being the number-two economy after the United States.

But with consumer demand in the West tepid at best (see Figure 1), this model is looking questionable. China managed to post an 8.7% annual growth rate in 2009, and a blistering 10.9% in the second quarter of 2010. This would normally be considered phenomenal. But 92% of the 2009 number was capital spending, a fair amount of which was spurred by government stimulus programs. If you take out capital spending investment, China's economy barely budged at all.



China is a unique case. Not all emerging economies are as heavily driven by infrastructure and construction spending. But the problem is that most emerging-market investment options for retail investors are weighted specifically to these sectors that I see as being the most at risk: financials, construction, and manufactured exports.

Enter the Emerging-Market Consumer

While I question the sustainability of the "Asian Model" of economic development, I'm not at all bearish on emerging markets in general. The rise of the emerging-market consumer is real, if Figure 2 is any indication. In Figure 2 we can see that Indian and Brazilian consumers barely missed a beat during the crisis. Consumer spending continues to soar higher.



So, how do we as passive portfolio investors profit from these trends?

In the Sizemore Investment Letter, I've thus far chosen to invest mostly indirectly, buying Western firms like Philip Morris International (PM) and Telefónica (TEF), which have a strong presence in emerging markets. My only direct investment thus far has been in Turkcell (TKC), the leading mobile communications company in Turkey.

The standard answer for most investors, however, has been to buy an emerging-market mutual fund or ETF like the popular iShares MSCI Emering Market Index Fund (EEM). The problem is that this ETF is perhaps the most poorly named ETF in history. It's not a play on emerging markets at all. It's primarily an indirect play on the American consumer, as most of its constituent parts are export-oriented companies, materials companies, and banks.



Take a look at Figure 3, which lists EEM's largest holdings. Samsung and Taiwan Semiconductor top the list, followed by a string of banks and oil companies. This is hardly a play on the emerging-market consumer. What's more, consider the country concentrations in Figure 4.





China and Brazil have the largest concentration, which is fine. But following Brazil, South Korea and Taiwan make up a combined 24% of the fund. Nothing against these countries, of course, but it's hard to really consider them "emerging markets" today. If Greece and Portugal are considered "developed countries," then why aren't South Korea and Taiwan? (MSCI considers certain factors such as the convertibility of the local currency as criteria. Still, my point stands.)

Up until very recently, Israel also had a fair-sized allocation in the fund. It's hard to see what Israel -- which is second only to Silicon Valley in tech start-ups -- was doing in an index full of South American and Pacific Rim developing countries.