Emerging markets are out of favour. The BRIC contingent are all suffering to a greater or lesser extent with Brazil’s economy in free-fall, Russia stung by collapsing oil prices, India performing relatively well but constrained by political turmoil and China enduring a hard landing as it makes the transition from an export driven to consumer driven economy.

The weak sentiment towards emerging markets could be an opportunity for brave and risk-tolerant investors. In commentary outlining the attractions of Chinese fixed income, specialist asset manager Ashmore’s head of research Jan Dehn says: ‘It is precisely because of the cautious sentiment which prevails during the transition that we like the fixed income markets in China.

‘But given that China’s current challenges are transitional in nature, it is equally true that equity investors are likely to be rewarded handsomely if they begin to position for China’s future as a consumption-led economy.’

Although emerging markets are becoming more open to outside investment, restrictions on foreign ownership remain and there are other challenges like liquidity, different time zones, not to mention bureaucracy, corruption and their sheer remoteness from UK investors.

Straightforward and low cost

As Amanda Rebello, head of ETF sales for the UK Ireland and the Channel Islands, Deutsche Asset Management, notes, exchange-traded funds (ETFs) can offer a relatively straightforward means of gaining diversified exposure to emerging markets.

‘For retail investors it may be difficult to do the necessary research to pursue a direct stock picking approach. In terms of what is available on the active side, it tends to be more broad-based. ETFs offer more precise exposure with individual countries and even sectors within those countries.

‘With an emerging markets ETF you also have tradability throughout the day, whereas if you were buying the individual stocks you would have to execute over several time zones.’

Viktor Nossek director of research at WisdomTree Europe, says ETFs compare favourably with mutual funds when it comes to emerging markets thanks to their inherent transparency. ‘I think first of all ETFs give you a fairly transparent approach to investing in the first place irrespective of geography. However in particular with emerging markets it is important to know what is in the underlying basket.

‘With mutual funds, you are trusting the fund manager to pick the right stocks and often they will only disclose the top 10 holdings leaving everything else undisclosed.’

Increasing range

Although there is not quite the range of ETF options as is available on developed markets the range is increasing. A quick search on industry information site JustETF shows 48 emerging markets equity ETFs and 13 fixed income ETFs.

As with all ETFs, you need to know the make-up of the index underlying the product as Deutsche’s Rebello explains.

‘It is important you understand the composition of the underlying index - for example the FTSE Emerging Markets index excludes South Korea while the MSCI version includes South Korea. You can also drill down further and find out if the access to emerging markets is through ADRs or GDRs on the New York or London international exchanges or equity listings on the relevant local exchange.’

Nossek adds: ‘At times of market volatility and disappointment, transparency becomes even more important. If you now think the emerging markets represent a value proposition as the market correction is disproportionate relative to the weakening of fundamentals and you want to tiptoe back into emerging markets you need to think about how you are going to get exposure. You need to consider, for example, how frequently the basket of stocks rebalance and how they are screened.’

Cost is another factor. Intense competition between ETF providers means the total expense ratios (TERs) on mainstream ETFs have been cut to the bone - some products tracking the FTSE 100 have TERs of less than 10 basis points.

The same is not true for emerging markets ETFs where TERs of 0.5% and upwards are the norm. In part this reflects the greater complexities involved in constructing and running products targeting these markets but it also reflects the more limited number of providers and products in this space.

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Liquidity issues

Emerging markets stocks are typically less liquid than their developed market counterparts because, by definition, their markets are still in the development stage with less domestic investors on hand to buy and sell equities. As a result, an emerging markets ETF could trade on a higher bid/offer spread, thereby adversely impacting returns.

Because ETFs have several layers of liquidity the product itself can be more liquid than the market it is tracking. Deutsche’s Rebello cites the example of the db X-trackers Emerging Markets Liquid Eurobond UCITS ETF (XEMB) where the basket of bonds being tracked have bid/offer spreads of between 70 and 100 basis points whereas the ETF itself has an average bid/offer spread of around 50 basis points.

The liquidity issues in certain emerging markets can also make it difficult to use physical replication to achieve the performance of an index. For background, physically-backed products trade directly to replicate the performance of a market, while synthetic ETFs employ a swap-based method of replication, investing in derivatives contracts offered by brokers and investment banks. The relative simplicity of physical replication means this is by far the preferred method for most investors.

For example, even though Deutsche Asset Management’s bias is now towards physical replication on all its new product launches, db X-trackers MSCI GCC Select Index (XGLF) launched last year to track the six equity markets in the Gulf Cooperation Council uses synthetic replication because of the difficulties involved in accessing the Saudi Arabian market directly.

Nossek from WisdomTree says it uses physically optimized or sampled replication where if an individual stock or group of stocks are too illiquid an index fund might be used instead as a proxy.

Innovation

Like all aspects of the ETF industry the emerging markets offering is likely to develop over time with an increasing range and breadth of products including smart-beta ETFs. WisdomTree has a number of smart-beta emerging market ETFs which track a basket of stocks based on certain criteria. Among them is WisdomTree Emerging Markets SmallCap Dividend (DGSE) which includes small cap emerging markets stocks weighted by total dividend payments in dollar terms.

Pressure on emerging markets currencies has ramped up as commodity prices have collapsed and the US Federal Reserve increased interest rates - thereby boosting the attractiveness of the dollar. This means returns from sterling and dollar denominated emerging markets ETFs have suffered.

A possible solution to this problem are currency hedged products which seek to limit the impact of forex movements on returns. However WisdomTree’s Nossek says the costs of implementing currency hedging on an emerging markets ETF would likely be prohibitive for now.