ETF Expert

In one form or another, I continue to get the question: Do you STILL think emerging markets are safer than the U.S.? Answer… Yes.

This is not to say that emerging market ETFs aren’t extensively overbought. They are. And it’s not to say that they won’t get whacked for 15%-20% losses if the U.S. is hit for a 10%-12% downdraft. Emerging market ETFs will get whacked.

What I have been saying throughout this incredible uptrend for emerging markets is that investors should recalibrate the way that they think about risk.  The premise of “safety” must go beyond measures of volatility — measures that only account for one-on-one comparisons rather than accounting for the risk reduction inherent to a well-diversified portfolio. Moreover, “safety” might incorporate the direction of a country’s credit ratings, the direction of its currency and the strength of its expansion.

1. Risk of EM exposure declines in a diversified portfolio. Murray Coleman at Index Universe showed that moving an all-international stock portfolio from 5% iShares MSCI Emerging Markets (EEM) to 10% resulted in negligible changes to portfolio volatility (risk). However, the increase in rewards were fairly substantial.

I conducted a similar experiment with an all-stock portfolio — developed markets versus emerging markets. In an all-stock portfolio with 66.6% developed world markets (i.e., iShares Europe 350 IEV and the S&P 500 SPDR Trust SPY) and 33.4% emerging markets (i.e. Vanguard Emerging Market VWO), the portfolio showed volatility that was 1 ¼ more “risky” than the S&P 500.

Then I flipped the portfolio such that you had 66.6% emerging markets and 33.4% developed world markets. The portfolio had jumped to 1 and 1/3 more “risky” than the S&P 500. Here we can see that we’ve doubled the emerging market exposure from 33% to 66%, while only bumping up the volatility from 1.25x the S&P 500 to 1.33x the S&P 500. The rewards for doing so should make any student of “risk” think about the narrow way that textbooks define it.

2. Limiting the risk of “outliving” your money. Regardless of the U.S., Japan and Europe’s ability to finance its debts, the 10-year direction of developed market currencies is down. If your U.S. dollar is worth less and less, your purchasing power is significantly hampered.

One way to fight “greenback emissions” is with stocks. They give a portfolio a fighting chance. Even bettter, foreign companies earn their profits in foreign dollars such that your stocks also get the currency conversion benefits.

In fact, emerging market currencies are those that are most likely to climb in the next decade. That bodes well for currency ETFs like the Brazilian $ Real (BZF) , bond ETFs like PowerShares Emerging Market Sovereign (PCY) as well as low cost stock index funds like Vanguard Emerging Markets (VWO).

3. Emerging markets have less risk of economic contraction. Sure the U.S economy may prove more resilient than people give it credit for. Yet higher-end forecasts see a tepid, slow-growth environment below historical trend. Many others, Nouriel Roubini, keep pressing the idea that a double-digit recession is in the U.S. house of cards.

Western Europe’s prognosis? Not a whole heck of a lot better. 1%-1.5% Euro-Area growth for 2010.

Meanwhile, we have China, India, Vietnam, Indonesia, Brazil, and the vast majority of Southeast Asia projected to return to full strength. There isn’t the same talk about a global economic meltdown, though it is clear that the emergers need the developed countries to remain relatively stable.

The future seems to suggest that developed economies are at risk of stagnation or ”stagflation.” And while emerging economies may have been more fragile in the past, what hasn’t killed them appears to be making them stronger.   

So I’ll say it again… just as I said it in May. The largest countries in Japan, the U.S. and western Europe may have more to lose, from currency devaluation to credit rating downgrades to economic stagnation. When you put these factors into your “risk” calculator, you may find yourself reassessing what safety is or is not.

If you’d like to learn more about ETF investing… then tune into ”In the Money With Gary Gordon.” You can listen to the show “LIVE”, via podcast or on your iPod.

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