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New ETF targets emerging markets' middle class

Chinese national flags fly in front of a newly built residential apartment in Wuhan, Hubei province, July 10, 2012.

DARLEY SHEN/Reuters

ETF provider Emerging Globalshares has made its name by being first to market in several areas of the emerging markets space. It has done so again with the new EG Shares Emerging Markets Domestic Demand ETF (EMDD). The name might not be too catchy but the exposure seeks to capitalize on the burgeoning middle class in many emerging market countries.

The driver of this segment is the demand that arises from more and more citizens of emerging market countries moving into more of a middle-class lifestyle. This transition is likely to be steadier than the growth of the broader economies of emerging market countries.

The "domestic demand" part of the fund's name means that the fund owns companies that offer products or services used on the ground in countries like Mexico, which is 24 per cent of the fund, China, 15 per cent, India, 14 per cent, and South Africa and Brazil at 13 per cent each, with other countries having smaller weightings.

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The largest sector is telecom at 29 per cent. This is logical in that almost every country on the planet has a large telephone country and thanks to cell phone availability, emerging market phone companies have not had to install wireline infrastructure to facilitate customer growth.

Consumer staples comprise 28 per cent, discretionary 26 per cent, utilities are almost 11 per cent of the fund with health care taking up the balance of the fund. There is no financial exposure, which should be a huge positive and a point of differentiation for EMDD because of how many emerging market funds have gross overweights in financials.

The reason that no financial exposure is a positive is that as countries like Brazil and China become more prosperous they will become more financially more complex. This creates visibility for excess in the respective banking systems, leading to 2008-like implosions for financial stocks in these countries.

Also missing is the energy sector. Similar to telecom, energy is an easy way to invest in foreign markets because so many countries have a large oil company. There are plenty of foreign oil stocks that trade in the U.S. as ADRs to capture the exposure along with ETFs from many providers including the EG Shares Energy GEMS ETF (OGEM).

That EMDD has no energy exposure is surprising, but most integrated oil companies are multi-national. For example, there is news on a regular basis about the Chinese oil majors investing all over the world, including Africa and South America, which would conflict with the domestic-demand theme of the fund.

The fund has 50 holdings and while Walmart de Mexico is likely to be familiar, most of the names will not. The EG Shares literature indicates that the index underlying the fund yields 2.62 which after accounting for the 0.85-per-cent fee means that the fund might yield 1.75 per cent.

There are quite a few countries that are either not represented in EMDD or do not have enough weight in the fund to have any meaningful impact on returns. Countries omitted include Colombia, Poland and Turkey. Countries that are too small to influence the fund's performance include Chile and Thailand.

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The countries that are omitted or simply have low weightings all have compelling stories and risk factors to sort out. But the biggest drawback to EMDD would appear to be the relatively large weightings to a handful of countries.

This is easily mitigated in the context of using EMDD as a core emerging market holding and filling in the gaps with smaller positions in individual stocks or narrower ETFs for segments not covered by EMDD. Lastly, given the relatively large weighting to Mexico it is important that anyone considering using this fund must be favourably disposed to investing in Mexico.

(At the time of publication, the author held no positions in any of the stocks mentioned.)

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