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Investors are putting more money into emerging market ETFs, attracted by surging economic growth in dominant countries like China and expected rising demand for clean energy and infrastructure spending amid a global economic recovery.

According to National Bank Financial data, emerging market (EM) ETFs have been picking up pace in Canada, with inflows valued at $1.7-billion in 2020, up from $800-million in 2019. Inflows dropped off in the U.S. to US$600-million in 2020 versus US$13.2-billion in 2019. However, the National Bank data shows $6.5-billion in inflows in EM ETFs in January alone, “quite a significant number,” says Daniel Straus, director of ETF research and strategy for National Bank Financial, while Canadian EM inflow came in at about $221-million.

Mr. Straus says investors have been inquiring about EM markets “because the strength and rapidity of the developed world’s post-pandemic stock market recovery,” which he adds “has once again left domestic valuations rather elevated.”

Adds Mr. Straus, “it’s possible that investors are being selective and looking for opportunities where the prospect of future growth is more attractive,” noting that the S&P 500 Index has a price-earnings ratio of 29.4 compared to 21.3 for the MSCI Emerging Market Index.

While there are risks with EM investing, such as increased volatility, geopolitical issues and currency fluctuations, observers believe the investments have room to grow, driven by sizeable holdings in China, one of the world’s largest economies.

“China is the fastest economic growth engine now, when the rest of the world is trying to recover,” from the economic impact of the pandemic, says Linda Zhang, CEO of Purview Investments, a portfolio management firm in New York focused on climate-resilient ETFs with an environmental, social and governance angle.

China’s gross domestic product grew 2.3 per cent in 2020 and was the only major global economy to avoid a contraction amid the economic fallout from the COVID-19 pandemic. China is also expected to be a powerhouse again this year, with GDP set to expand at the fastest pace in a decade at 8.4 per cent, according to a Reuters poll.

A recent National Bank report notes global fiscal and monetary stimuli to support household spending during the pandemic “has been a boon to the EM economies, where the bulk of manufactured goods are produced.”

Ms. Zhang says the COVID-19 crisis “has really become a watershed moment,” drawing attention to how much better the Asia-Pacific region has done in terms of public policy and general public attitudes toward managing the pandemic. The result has been an earlier economic recovery in many EM nations, with business activities rebounding much faster.

EM equities, which for some time have lagged behind the U.S. in performance, are becoming a more attractive asset class, Ms. Zhang says. She also sees a clean energy boom in China – one of the world’s largest producers of solar and wind power and electric-vehicle components – resulting from climate change initiatives being brought forward by the Biden administration, Europe’s ‘green recovery’ and China’s own carbon-reduction programs.

For EM ETFs, this means “you want to invest in these leaders in new industrial transition,” says Ms. Zhang, particularly in areas such as smart grids and high-speed rail. She suggests funds that reflect the “true Chinese economic vitality” and the country’s fastest-growing sectors, like technology and e-commerce, rather than broad-based emerging-market ETFs that include fossil fuels, the automotive industry and traditional banks.

Examples among U.S.-listed ETFs include the Emerging Markets Internet and Ecommerce ETF (EMQQ-A), which holds leading tech and e-commerce companies in emerging economies. Ms. Zhang’s firm invests in that fund as well as the KraneShares MSCI China Environment Index ETF (KGRN-A), which includes global companies that will benefit from the global push to renewable energies and the emission-free transitions of the power and transportation industries. EMQQ, with a management expense ratio (MER) of 0.86, is up 27 per cent so far this year and has more than doubled over the past year, while KGRN (MER of 0.79 per cent) is up 20 per cent so far in 2021 and has surged 170 per cent over the past year. (All data includes total returns from Morningstar as of Feb. 11).

She also suggests taking a look at a high-risk high growth play, the KraneShares SSE STAR Market 50 Index ETF (KSTR-A), a new emerging tech and science fund with an MER of 1 per cent launched in late January and listed on the Shanghai Stock Exchange STAR Market.

Alan Fustey, a portfolio manager based in Winnipeg at Adaptive ETF, a division of Bellwether Investment Management Inc., likes that EM equity prices are inexpensive relative to developed markets.

“Additionally, some of these countries have economies that are large commodity producers that would benefit from an increase in the rate of global inflation,” he says. This means they “are not something you buy and hold forever; you’re there on a more tactical positioning.”

Mr. Fustey says EM equities can be more volatile but sees growth potential, which increases its risk-reward potential. While China is a major part of these ETFs and the number-one sector is technology, he likes funds that give broad exposure to a diverse range of countries and sectors.

He suggests looking at the BMO MSCI Emerging Markets Index ETF (ZEM-T), a broad-based fund that replicates the performance of the MSCI Emerging Markets Index, capturing 26 emerging-market countries, including China. It has an MER of 0.27 per cent and has returned 12 per cent year-to-date and almost 30 per cent over the past year.

There’s also the U.S.-listed Vanguard FTSE Emerging Markets ETF (VWO-A), which replicates the FTSE Emerging Markets All Cap China A Inclusion Index, representing a range of companies in emerging markets around the world. It has an MER of 0.10 per cent and has returned 12 per cent so far in 2021 and about 30 per cent over the past year.

Benjamin Felix, a portfolio manager in Ottawa for PWL Capital Inc., also suggests diversifying across emerging-market countries and capitalizations. For example, the iShares Core MSCI Emerging Mkts IMI ETF (XEC-T) offers “a great diversification benefit” and is growing well, he notes. It has an MER of 0.27 per cent and has returned 11 per cent year-to-date and 27 per cent over the past year.

Meanwhile the U.S.-listed Avantis Emerging Markets Equity ETF (AVEM-A), with an MER of 0.33 per cent, covers similar holdings but captures stocks in companies that are lower in price relative to their book value. This means they could have higher returns while involving additional risk, he says, meaning the fund would do worse in a major market downturn. It has returned 12 per cent so far this year and 30 per cent over the past year.

While Mr. Felix allows that emerging markets are doing well as an asset class and “tilting toward higher expected returns,” he cautions that “buying after recent good performance, you could argue, is not the best time.”

Investors who get into an EM ETF should “commit to it, don’t jump back out if it has a bad couple of years,” Mr. Felix says. “Once the decision is made, it should be part of a long-term allocation.”

Emerging markets make up 10 to 15 per cent of the overall global market, Mr. Felix says, so that allocation makes sense in a typical portfolio. He says betting on a single emerging market “can be tricky,” because of “random risks associated with investing in individual countries.”

Ms. Zhang warns that China-led emerging-market growth does raise concerns given recent geopolitical tensions, for example, the U.S.-China trade war has banned some hot Chinese performers from U.S. stock exchanges. She notes that if capital restrictions were extended to more such companies, investors would have less access to the “true Chinese economy” in emerging-market ETFs.

She also suggests that investors try to look for EM ETFs considered to be underperforming and have the potential to climb. “You don’t want to buy a value trap.”

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