MARKET COMMENT

May 25, 2007



LOOKING FOR EMERGING MARKETS

Yesterday, Greg Newton and I had the privilege of conducting our third podcast interview with the Emerging Markets Monitor [London]. The link to the podcast is HERE. [Be prepared for a nearly 40 minute discussion which makes sense given the enormity of the topic and feel free to listen to previous podcasts as you wish.]

The topics covered included:

• What constitutes or defines an Emerging Market?
• What are current market conditions from regions to specific countries?
• Is the Chinese market too overheated?
• Did you know Chinese retail investors are opening one million new brokerage accounts per week? And that a leading government official stated that fully one third of Chinese publicly traded companies are “fundamentally unsound”?
• Where are new opportunities?
• Are some new and existing US ETFs suitably structured? Or, are they antiquated or even misleading in make-up?

Included in this discussion are some new Emerging Market ETFs and their structures. I was most anxious for State Street’s new Emerging Europe ETF [GUR] to be issued but found its structure disappointing. We discuss this in the podcast but I’d like to single it and a few others out in this post.

The number one criteria any investor should value when evaluating new or existing overseas related ETFs is the appropriateness and validity of the index and components to which it is linked. The structure we were looking for in GUR for example was a focus on what “we” considered to be Emerging Europe. That would include allocations to markets like Poland, Czechoslovakia, Greece, Turkey and Portugal for example. But what we found with GUR was a heavy weighting [nearly 60%] to Russia. Such a weighting, aside from the obvious, also means a heavy weighting in energy [nearly 50%] which includes Lukoil and Gazprom. This doesn’t fit the bill. The top sectors and country weights for GUR are below:




GAF [SPDR S&P Emerging Middle East & Africa] also carries a similar flaw in that 82% of the linked index weighting is divided between Israel and South Africa. This too is not what one would intuitively feel represents the Middle East and Africa. They may be the dominant indexes in such a wide region, but there are certainly other markets that could better represent the “theme”. In fact, an Islamic ETF may be the most suitable since it would cover Morocco, Egypt, Jordan, the Gulf States and Pakistan for example. That might be more interesting. GAF’s components are listed below:





The other criteria when evaluating indexes considers weightings as to whether the heavyweights can and should stand on their own. Clearly EZA [South Africa ETF] and the new RSX [Van Eck Russia ETF] qualify to be used exclusively given their uniqueness. Also, Barclay’s and another firm has an Israel ETF in registration, and upon release, they too can stand on their own. In other words, if you want Russia, buy RSX and South Africa, buy EZA.

Now not to knock all the new products from State Street, there are some that are intriguing and investors should consider.

GXC [SPDR S&P China ETF] may be a better alternative to the narrower FXI [FTSE Xinhua China ETF] since the latter only contains 25 former state companies while GXC has a much broader exposure. Its structure is outlined below:




An abbreviated sample of its holdings is below:





Let’s compare popular Barclay’s EEM [MSCI Emerging Market ETF] with the new GMM [SPDR S&P Emerging Markets ETF]. The question we discuss with Emerging Markets Monitor had to do whether South Korea was still an Emerging Market. This got us into an interesting discussion since according to the World Bank an Emerging Market is one “where the per capita income is less than $10, 726.” This is interesting since some wealthy countries with smaller populations and GDP like Bahrain would not qualify yet China for example with a large population and GDP would. This is interesting to think about. The EMM concluded the dilemma with Supreme Court Justice Potter Stewart’s observation about pornography, “you’ll know it when you see it.” But, at the same time, the EMM has also been promoting for several years a “convergence story” whereby smaller emerging markets are outgrowing their previous poor image and now becoming more like established markets. Given that, they conclude there are different layers of emerging market categories also outlined in the podcast.

That said, let’s look at the structure of the two ETF indexes and try to determine which makes the most sense going forward. First is GMM followed by EEM.




Then EEM follows:




We can’t complain about EEM since its doing well and linked to a well-established MSCI index. But, for our money we know South Korea can stand on its own as an individual holding with EWY [MSCI Korea ETF] like RSX and EZA for example. But the same can be said for other components of GMM. So you must make your choices and the process may become subjective.

State Street issued six new ETFs that included apart from those already highlighted, Latin America [GML] which aside from price [$66 versus $200] maintains a very similar structure when comparing the S&P Citigroup BMI Latin America Index to the MSCI Latin America Index. So it’s a wash.

The last issue is GMF [SPDR S&P Emerging Asia Pacific ETF] which is quite unlike popular Barclay’s EPP [MSCI Asia Pacific ex-Japan ETF].

GMF index [S&P Citigroup BMI Asia Pacific Emerging Index] holdings follow:




EPP index holdings:




With these two funds the omission of Australia and New Zealand in GMF is striking whereas with EPP the extraordinary heavy weight given to Australia is equally striking. Again, our judgment with EPP is that with two-thirds to Australia, just use EWA [iShares Australia ETF] if you wish to combine it with GMF.

CONCLUSION

It should be obvious that looks can be deceiving. As an investor you must look under the hood and find just what it is you’re looking for. It may be subjective since you might have your own fundamental view as to which index structures best suit your views--but, that’s okay. The important thing is to separate ETF titles from reality and invest with your eyes wide open.

Have a safe holiday weekend.

Disclaimer: Among other issues the ETF Digest maintains long or short positions in: FXI, EEM, EPP and ILF.