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One of the most common expressions in finance and economics is that there is no such thing as a free lunch; greater return means greater risk, or at least a lot more effort spent turning over rocks in the hunt for undervalued opportunities. Strangely enough, though, this saying is not completely true. Emerging market ETFs are not necessarily a free lunch on their own, but they can have a very positive effect on a diversified portfolio.

Growth Means Performance

Simply put, emerging markets generally outperform developed markets because the underlying economies are growing quite a bit faster. As per IMF data, the global economy grew about 5% in 2010, with developed economies growing 3% and emerging economies growing 7.3%. That spread also holds up through the worst of the past recession – emerging economies outgrew the developed economies by 3.2% in 2009.
What’s more, the prospects for growth are generally better in these economies. Many of these countries have very young populations and increasingly liberalized rules regarding starting and operating a business. Not only is there a surge in new business creation, then, but the improvement in the standard of living allows more consumers to buy more and better goods, furthering the growth and potential of the domestic markets and the companies that serve them.
Better Risk

Emerging market investing is often seen as a high-risk endeavor, but that is not always true. It is true that the returns from emerging markets are generally more volatile than more developed markets, but the stock market swoons tied to the tech bubble and the housing bubble should be ample proof that volatility is a global phenomenon. What’s more, ETFs do mitigate some of the risks of emerging markets by holding large diversified portfolios, often including large allocations to utility sectors that tend to be more predictable.
What is interesting about emerging market ETFs is how they can alter the risk exposure of a diversified portfolio. Emerging stock markets tend to show low correlation to the U.S. market – that is, the movements in those stock markets are not closely tied to the movements in the U.S. market. That means, then, that these markets can go up even while the U.S. market is declining. This actually helps to reduce the overall volatility and risk of a portfolio.
The Numbers

The table below highlights some interesting benefits and drawbacks to ETF investing in the emerging markets space. For the most part, performance compares favorably to the roughly 17% return in the S&P 500 over the same one-year time frame. What is interesting, though, is the relative lack of five-year data – there has long been a relative dearth of investment options for emerging market investors, and many of these ETFs are only a few years old as sponsors move to fill the void. For those ETFs where five-year data is available, however, it compares quite favorably to the roughly 3% return on the S&P.

The Bottom Line

Emerging market ETFs are a convenient and cost-effective way to invest in some of the most interesting and dynamic markets for the next 20 or 30 years. What’s more, the higher growth of these economies often translates into better relative stock market performance. Couple that performance with lower over portfolio risk (the benefits of diversification and low correlation) and investors really can enjoy the next best thing to a free lunch – a portfolio that does better over time, with less risk and volatility.