FTSE 100, DAX ETFs offer alternative gateway to emerging markets growth, says iShares

Apr 8th, 2013 | By | Category: Equities

The potential of emerging markets (EM) is well understood, underpinned by superior growth and robust credit fundamentals. But with recent emerging markets equity performance poor, developed market large-cap corporates could provide an attractive, alternative gateway to this potential.

FTSE 100, DAX ETFs offer alternative gateway to emerging markets growth, says iShares

Stephen Cohen, Head of EMEA Investment Strategy and Insights Team, iShares.

Growth in emerging markets continues to stay positive versus developed markets, with emerging countries expected to grow at a rate 4% higher than developed countries in 2013, according to the IMF.

Emerging market countries also often have healthier fiscal positions. While many developed countries have recently been downgraded (US, UK, France, Italy, Spain, Greece etc), numerous emerging market sovereigns have enjoyed credit rating upgrades, including Brazil, Indonesia, Peru and, most recently, the Philippines.

However, despite the positive outlook, emerging markets have underperformed developed markets year-to-date (YTD), a trend continued from last year. The MSCI Emerging Markets Index, for example, is down 4.46% so far this year, compared to the MSCI World Index, a developed market benchmark, which is up 6.02%. Moreover, this underperformance has been accompanied by higher volatility, in part because developed market volatility has been somewhat suppressed through programmes such as the quantitative easing.

In light of the disappointing performance and higher volatility of emerging market equities, accessing the potential of emerging markets via developed market equities is an attractive alternative, reckons Stephen Cohen, Head of EMEA Investment Strategy and Insights Team at iShares, the world’s largest provider of exchange-traded funds (ETFs).

He says: “The benefits of EM through developed markets are plenty: Some of the highest quality and most stable developed market companies have made great inroads into emerging economies. There will also be less political and foreign ownership risk, and better governance as developed market equities may be subject to higher regulatory standards. In short, investing in emerging markets through developed markets provides a compromise between the two investment worlds, with potential for enhanced risk return.”

Cohen notes that large-cap corporates, such as those of the UK and Germany, as represented by the FTSE 100 and DAX indices respectively, tend to offer higher exposure to emerging markets compared to mid- and small-caps, due to the minimum thresholds needed to set up international trade partnerships and economies of scale.

UK large-caps derive more than 90% of their underlying sales revenue from overseas; 29% of revenue comes from emerging markets, significantly higher than corresponding exposures for the mid-cap and small-caps segments. Companies such as HSBC, Standard Chartered, British American Tobacco, Unilever, and BHP Billiton are among the FTSE 100’s major emerging markets earners.

Similarly, the German DAX has 31% sales revenue exposure to emerging markets. This is comparable to the MSCI Australia Index, which is often seen as an emerging market proxy within the developed world (Australia is a major exporter of commodities to emerging market countries, particularly in Asia). DAX constituents earning a significant proportion of revenue from emerging markets include Bayer, Siemens, BASF, Daimler and BMW.

When compared to the broader German market, such as the MSCI Germany Index, which has 19% sales revenue exposure, the DAX is significantly more emerging market exposed. In fact, historically, the DAX has tracked well a basket of 10 currencies most associated with China in terms of trading partnerships, reflecting the impact of currency on corporate profits as a result of the exposure of German companies to emerging markets.

This theme – accessing emerging markets growth via developed market companies – has been recognised by index providers, who have launched a range of innovative indices tracking such investments. MSCI, Russell and Stoxx all offer interesting plays on the concept. Examples include the MSCI World with EM Exposure Index, the Russell Developed Large Cap EM GeoExposure Index and the Stoxx Global 1800 EM Exposed Index. The MSCI World with EM Exposure Index has outperformed the MSCI Emerging Markets Index by 4.22% YTD, though has lagged the MSCI World.

While the aforementioned index providers are thought to have marketed these indices to ETF providers, as yet no such product has been launched. Investors do, however, have a range of options when it comes to accessing the FTSE 100 and DAX. Among the most popular FTSE 100 ETFs are the iShares FTSE 100 ETF (ISF) with £3.8 billion in assets, the HSBC FTSE 100 ETF (HUKX) with £365 million, and the Vanguard FTSE 100 ETF (VUKE), which is the cheapest, charging just 0.10% per annum. For DAX exposure, among the most popular funds are the iShares DAX ETF (DE) (EXS1) with with £11.4 billion in assets, the db X-trackers DAX UCITS ETF (XDAX) with £5.9 billion, and the Lyxor ETF DAX (LYXDAX) with £541 million.

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