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Emerging Economy ETFs: Better Diversification Means Less Portfolio Risk

16 September 2010 at 1:24 pm by Gary Gordon     Bookmark and Share    Follow EtfExpert on Twitter

Over the last 6 months, the stock ETFs of different economies have largely traveled in the same direction. If stocks were up in China, they were probably up in India, the European Union as well as the¬†United States. If stocks were down in China, well… you get the picture.

The correlations between the 10 largest economies in the world were particularly strong; that is, with correlation coefficients of .85-.95 across the board, you could almost bank on directionality.

On the other hand, you’d have¬†had a bit of¬†trouble¬†with the magnitude of the percentage gains (losses). Here’s a snapshot of 6-month returns for the 10 largest economies:

6-Month Rolling Returns For The 10 Largest Economies In The World  
          Econ Rank Approx %
WisdomTree India Earnings (EPI)   8   11.2%
PowerShares Golden Dragon China (PGJ)   3   1.4%
iShares United Kingdom (EWU)     5   0.1%
iShares MSCI Brazil (EWZ)     6   -0.3%
iShares MSCI Canada (EWC)     7   -1.2%
SPDR S&P 500 Trust (SPY)     2   -3.3%
iShares MSCI Australia (EWA)     10   -4.0%
iShares MSCI Japan (EWJ)     4   -5.3%
Market Vectors Russia (RSX)     9   -5.4%
iShares MSCI European Union (EZU)   1   -7.1%


When you look at the smallest economies for which an ETF is available, however, correlation coefficients become noticeably smaller. For instance, ETFs representing Vietnam, Columbia, Thailand and Chile show 6-month correlations as low as .50.

The implications? While emerging¬†economy¬†ETFs¬†still tend to¬†move in¬†the same direction as other economy ETFs (large and small), the¬†relationship is far more modest. That’s an advantage for constructing a well-diversified portfolio. In fact, you want lower-correlating assets¬†so that some investments are zigging when others are zagging.¬†That’s the very essence of diversification.

With respect to the magnitude of gains and losses… the emerging economy run has been breath-taking:

iShares MSCI Chile (ECH)     46   31.2%
Global X InterBolsa Colombia 20 (GXG)   36   27.2%
iShares MSCI Thailand (THD)     33   24.5%
iShares MSCI Peru (EPU)     51   22.5%
iShares MSCI Turkey (TUR)     17   22.4%
iShares MSCI Malaysia (EWM)     41   21.0%
iShares MSCI Singapore (EWS)     43   11.0%
iShares MSCI South Africa (EZA)     32   4.5%
Market Vectors Vietnam (VNM)     57   -7.2%
iShares MSCI Israel (EIS)     40   -11.1%


Granted, it is¬†foolish to use¬†super-sized returns as the sole basis for investing in an asset grouping (e.g.,¬†emerging market stock ETFs, etc.). With that said, it is just as foolish to write off emerging economies as “too volatile.” On the contrary! When you incorporate¬†smaller economy investments into a big picture portfolio, you enhance your diversification.¬†The more diversified your overall portfolio, the lower the overall risk.

You can listen to the¬†ETF Expert Radio¬†Show¬†‚ÄúLIVE‚ÄĚ,¬†via podcast or on your iPod.¬†You can review more ETF Expert features here.

Disclosure Statement: ETF Expert¬†is a web log (‚ÄĚblog‚ÄĚ) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships. You may review additional ETF Expert disclosure details here.

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