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Like Emerging Markets? Try Markets That Are Really Emerging


Looking past BRIC, once less attractive markets are now offering potential for growth.

As everybody knows, the world's top stock markets started 2013 on the right foot. New York, London and Tokyo all racked up their best Januarys in many a moon. Emerging markets are lagging behind.

The popular ETF from iShares that tracks the benchmark, MSCI Emerging Market Index (NYSEARCA:EEM), has fallen by about 1% so far this year, and scratched out a 4.9% gain over the past three months. That compares with +6.1% and 6.5% for the S&P 500. Japan's smoking Nikkei 225 (INDEXNIKKEI:NI225) has surged by 9.2% year-to-date, and 27% over the past quarter. Even recessionary Europe's Euro Stoxx 50 (NYSEARCA:FEZ) index was outperforming global emerging markets until a sell-off over the past week.

This seems to make no sense. Every economist everywhere agrees that the developing world will produce most of the planet's growth for at least the next generation. So how can emerging markets be bringing up the rear as global investors shift to their most bullish mood in years?

Part of the reason is that the huge companies and superstates that dominate the global indices are not as emerging as they used to be. The whole idea of emerging market investing is to find companies that can promise several years of double-digit if not geometric profit growth, enough upside to offset the manifold risks of politics, governance, and simply putting money into places that you do not really understand.

Companies achieve that growth in one of several ways: being tethered to a domestic economy or economic sector that is on steroids, exporting a commodity whose price is soaring, or going through a positive internal revolution in management or governance. During the halcyon emerging markets days that preceded the 2008 market crash, those growth conditions were centered on the BRIC countries plus a few outlying raw materials producers.

The index-driven holdings of EEM and competitors like the Vanguard FTSE Emerging Markets ETF (NYSEARCA:VWO) reflect this history. EEM's top 10 companies include two enormous state-owned banks in China, one enormous state-owned bank in Russia, and two enormous energy producers in Russia and Brazil -- Gazprom (PINK:OGZPY) and Petrobras (NYSE:PBR). These are all solid corporations that are not going anywhere, but none is exactly in an explosive phase of its development: the fund's top two holdings are Samsung (PINK:SSNLF) and Taiwan Semiconductor (NYSE:TSM), which could only be considered emerging-markets companies at a stretch.

The general effect is one of investing in yesterday's (or last decade's) growth. For one thing, the BRICs are sputtering as engines of economic growth. Bloomberg came out last week with a ranking of the top 20 emerging markets. This was a mechanical exercise mashing up growth and debt statistics in a quantitative blender, but revealing nonetheless. China hung onto first place, but Russia was No. 9, Brazil 17, and India off the list altogether.

The fastest growing economies are not necessarily the most attractive for an armchair investor. South Sudan, for instance, will get the growth silver medal over the next five years, according to the International Monetary Fund. Iraq takes fifth place. China, at No. 9, is the only viable securities market in the top 20. But the Bloomberg list does offer plausible alternative destinations to the slowing BRICs – No. 3 Thailand, for example, or No. 7 Turkey.

A more nuanced issue is that growth within the big emerging markets has shifted from export industries and infrastructure investment to domestic consumption driven by the burgeoning middle class. The service sector's share in China's GDP rose from 39% in 2007 to 43% in 2011, and the government targets another 4% increase by 2015. That is a seismic shift in macroeconomic terms, and other markets are following a similar trajectory.

So you might expect better returns from investment vehicles that focus on emerging markets "beyond" the BRICs, or on consumer companies. And you would be right. Guggenheim's Frontier Markets ETF (NYSEARCA:FRN) has gained 2.6% during 2013 and 6.8% over the past three months. That compares with -1.5% and +3% for the same manager's BRIC ETF (NYSEARCA:EEB). The Frontier Markets fund's top holding is Ecopetrol (NYSE:EC), a rapidly expanding Ecuadoran oil company, followed by Chile-based Latam Airlines (NYSE:LFL) and Bancolombia (NYSE:CIB).

A similarly encouraging picture comes from EG Shares Emerging Markets Consumer ETF (NYSEARCA:ECON): up 1.6% year-to-date and 8.9% for the past three months. Top holdings here include Brazilian drinks powerhouses Companhia de Bebidas das Americas (NYSE:ABV), South African-based media empire Naspers (PINK:NPSNY), and Wal-Mart de Mexico (PINK:WMMVY).

These cutting-edge funds are orders of magnitude smaller than the $50 billion EEM. Their shareholdings are more concentrated, too, which could spell more volatility. But you don't go into emerging markets to play it safe. Try markets that are really emerging.
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