Adding Emerging Markets to Your Portfolio

This is the seventh lesson in our 10-part series on personal investing from Leland Hevner, author of The Perfect Portfolio and our friends at the National Association of Online Investors. The first six lessons are available to JK Lasser members and can be found here.

Review of Lesson 6: In Lesson 6, I discussed how to add a real estate component to the target market segment of the portfolio we are building in this 10-lesson course. In Lessons 3, 4, and 5, I showed you how to add gold, energy, and agricultural commodities. In this lesson, we will consider introducing an emerging markets component to the portfolio. Note that this lesson and all others in this course are excerpted from my book The Perfect Portfolio (Wiley, 2009).

The purpose of this lesson is to complete the building of the portfolio target market segment, that we began creating in Lesson 3, by adding an investment related to emerging markets. For reasons explained in previous lessons, my investment vehicle of choice will be an exchange-traded fund (ETF) for this market segment. In this lesson, I will illustrate how to find the "best" emerging markets ETF for the portfolio and then how to decide if now is a good time to buy.

Let's start the process by discussing the emerging markets investment market in general.

What Are Emerging Markets?

To be classified as an emerging market, a nation's economy must be progressing toward becoming an advanced economy, as evidenced by liquidity in local debt and equity markets and by the existence of some form of market exchange and an equities regulatory body.

Emerging markets generally do not have the level of market efficiency and strict standards in accounting and securities regulation to be on par with advanced economies (such as the United Stated, Europe, and Japan), but emerging markets will typically have a physical financial infrastructure, including banks, a stock exchange, and a unified currency. 

Why Invest In Emerging Markets?

We, as investors, look to emerging market investments for the potential of earning high returns, as they often experience faster economic growth as measured by gross domestic product (GDP) than do advanced economies. But there is added risk. Investments in emerging markets are more volatile due to the potential of political instability, domestic infrastructure problems, currency fluctuations, and various degrees of government control over companies (as in China's unique version of "capitalism"). Also, local stock exchanges may not make it easy for foreign investors to participate. 

Another reason that international investing is attractive is that real returns from securities denominated in foreign currencies go up when the U.S. dollar weakens.

Investments in emerging markets also enable investors to guard against weakness in the U.S. economy because many companies in emerging markets deal with commodities such as gold and oil, which are hard assets that can be a great hedge against inflation in the U.S.

Types of Emerging Market Investments

The world of emerging market investing is wide and diverse. It includes investments at all points on the spectrum from single countries to worldwide. Here are the four types of emerging market ETFs we will consider:

• Single Country: You can find an ETF that focuses on stocks in a single emerging market country. An example is FXI for investing in China.
• Region: There are ETFs for emerging market stocks in specific geographic regions such as eastern Europe, Asia, and Latin America. An example is GML for Latin America.
• Select Countries: There is a special category for ETFs that follow specific emerging market countries selected from around the world based on their potential for growth. The most common combination of such countries is Brazil, Russia, India, and China, commonly referred to as the BRIC countries. An example ETF for this type of investment is BIK.
• World: Finally, there are ETFs that contain emerging market stocks from countries around the world. An example is EEM.

Finding and Comparing Emerging Market ETFs

Now it is time to select and compare potential candidates for the emerging markets component of my portfolio. The candidates I will use in this lesson are the ones I have just mentioned. They give us the full range of geographic scopes making the comparison most valuable. If you would like to consider other, or more, ETFs, you can find them at finance.yahoo.com/etf. In the left column, click "ETF Center." On the resulting page, locate the drop-down menu labeled "Category" and from the list select "Diversified Emerging Category."

Here is a summary of my candidates:

• FXI (Single Country): This investment seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the FTSE/Xinhua China 25 index. The Underlying index consists of 25 of the largest and most liquid Chinese companies.
• GML (Region): This investment seeks to replicate as closely as possible, before fees and expenses, the total return performance of an equity index based on the Latin American equity markets. The fund invests in publicly traded companies domiciled in emerging Latin American markets. It consists of companies from Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela.
• BIK (Selected Countries): This investment seeks to replicate as closely as possible, before fees and expenses, the total return performance of an equity index based on the emerging markets of Brazil, Russia, India, and China (often referred to as the BRIC countries). The fund uses a passive management strategy designed to track the total return performance of the S&P BRIC 40 index, which provides exposure to 40 leading companies domiciled in the emerging markets of Brazil, Russia, India, and China that are listed on the Hong Kong Stock Exchange, the London Stock Exchange, Nasdaq, and/or the NYSE.
• EEM (Worldwide): This investment seeks results that correspond generally to the price and yield performance of the MSCI Emerging Markets index. The fund generally invests at least 90% of assets in the securities of its underlying index or in ADRs and GDRs representing such securities. The index was developed by MSCI as an equity benchmark for international stock performance.

These are my emerging market ETF investment candidates, each with a different geographic focus. You can certainly compare others, but I suggest that you compare at least three. To view the companies that each of these ETFs holds, you can go to finance.yahoo.com, enter the ETF symbol on the home page, and click "Holdings" in the menu.

My next step is to collect data for each candidate in order to determine which I feel to be the "best" for the emerging markets component of my portfolio.

The Data Collection Worksheet and Web Site

Following is the same ETF data collection worksheet and web site that I used in previous lessons and will continue to use for emerging markets.

ETF	Returns			Risk	Expenses	Avg. Volume
	YTD	1 Year	3 Years

To fill in the blanks, I will use the site at www.morningstar.com. Following are the menu items to click on this site after entering the ETF symbol on the home page:

• Returns: On the page that will be presented after entering the ETF symbol, click "Performance" in the horizontal menu above the quote information. On the resulting page scroll down and you will see the numbers needed to fill in the three "Returns" columns of the worksheet. Keep in mind that many ETFs are relatively new and will not have a 3-year returns number.
• Risk: Click "Ratings and Risk" in the menu and look for "Standard Deviation." This is a measure of the ETF's volatility. The higher this number, the riskier the investment. Note that this number is typically based on three years of returns data and may not be available for newer ETFs.
• Expenses: This number represents an expense charged by the issuers of the ETF; it comes off your total return so the lower the better. To find expenses click "Fees and Expenses" in the menu. Use the "Total Expense Ratio." It is also shown on the "Quote" page.
• Average Volume: You will find "average daily volume" on the original "Quote" page. ETFs with low volume have a large bid-ask price and are more subject to dramatic price moves so look for one that trades at least 300,000 shares per day.
• Fund Summary: For a quick summary of the ETF's investing objective and what it holds scroll down on the "Quote" page and scan the "Morningstar's Take" section and also view the "Holdings" information. You will find, however, that to read the full Morningstar Analyst Report requires a premium membership. A free summary is found at finance.yahoo.com in the "Profile" section.

With the ETF data collection process in place, let's get the numbers for our candidates.

Collecting Data

Using the Web resources, worksheet, and process discussed above, I collected the following data for my ETF candidates. Keep in mind that this will not be current data at the time you read this lesson. Complete your own worksheet with current data.

ETF	Market Returns			Risk	Expenses	Avg. Volume
	YTD	1 Year	3 Years
FXI	48.28%	31.70%	17.17%	41%	.73%	19M
GML	90.72%	63.28%	N/A	N/A	.59%	47K
BIK	74.91%	49.54%	N/A	N/A	.50%	176K
EEM	62.42%	36.42%	7.95%	31.77%	.72%	67M

Note: Morningstar calculates market return by taking the change in the fund's market price, reinvesting all income and capital-gains distributions during the period, and dividing by the starting market price.

Candidate Observations and Selection

Here, we have an array of very attractive candidates. They have produced excellent returns in the past year and particularly year-to-date. But I must be very careful as the risk numbers are also extremely high. So, if I decide to buy, it will not be a buy-and-hold investment. It will be very closely monitored by a trading plan as discussed below.

Now, let's look at the pros and cons of each of our candidates.

• FXI is focused only on China stocks, making it the most susceptible to country risk. On the plus side, there is exceptional trading volume, and this makes it very liquid.
• GML focuses on the Latin America region, so country risk is reduced and the returns are the best of class. On the downside, there is very little volume for this ETF, and this makes bid-ask price spreads relatively large. If I trade this with any frequency, this could be an issue. It is hard to assess risk, as the ETF does not have a 3-year returns history.
• BIK invests in the BRIC countries. Returns are excellent, and it is somewhat diversified. Volume is not great but would not eliminate this investment if all other factors were superior. Again, no risk figure is available as the ETF is relatively new.
• EEM is the most diversified candidate as it owns stocks from countries from around the world. Its returns, while not the best in this group, are still staggeringly high. This is an established ETF with sufficient history to give me a risk number that is significantly below FXI. And the trading volume is the best in this space.

Based on this analysis, I will select EEM for my emerging markets portfolio candidate. Others viewing the same data may arrive at a different conclusion.

Having selected my ETF, now I need to look at its price chart and decide if now is the time to buy.

Price Chart Analysis

Following is a simple 6-month price chart of EEM as of the time of this writing. I obtained it by going to finance.yahoo.com, entering EEM in the "Quote" box and clicking on 6M (6 months) below the thumbnail chart. Obviously, the chart you view will look different, so simply take note of the analysis methodology described below and apply it to a current chart for EEM.

Chart Analysis

When viewing a chart, we need to look at the following items:

• Trend and Volatility: I do not want to buy an investment that is clearly trending down. In this chart I see that the recent trend is generally upward, with gains of close to 40% in just the past 6 months. The chart also shows that this is a moderately volatile investment with significant price swings up and down even as the overall trend moves higher. But volatility is not a bad thing in the target market segment of our portfolio, as we will be monitoring this investment and buying/selling via an automated trading plan. Significant price swings give us the opportunity to buy on dips and sell on upward spikes multiple times in relatively short time frames.
• Price Support and Resistance: I also look at the chart to identify support levels, where the price tends to "bounce" up, and resistance levels, where the price tends to "bounce" down. On this chart the current price is approximately $40. From May through July a level of resistance seems to have formed at $35. But at the end of July this resistance point was penetrated and at least in the short term it seems that $35 has transformed into a support level. These observations will form the basis of a trading plan should I decide to buy EEM at this time.

Analysis

I now have the information I need to decide if I want to place an emerging markets component in my portfolio now. I have two areas of analysis to consider: longer-term market factors and shorter term charting/trading factors.

At the time of this writing, the U.S. dollar continues to weaken and this is a plus for investing internationally. When an investment is denominated in a foreign currency and the dollar weakens against it, the investment appreciates on that fact alone. This is a positive factor for my decision process.

I also know that the threat of inflation looms over the U.S. economy as government spending spirals upward with no end in sight. In such an environment investors look to commodities to protect themselves. I also know that in emerging market ETFs many of the stocks owned are based on commodities such as gold and oil. This is another positive factor in my analysis.

Yet I am worried that EEM may be "overbought" at this point and forming a bubble that may burst at any moment. But I also know that if I put in place the proper trading plan I can limit my downside risk while riding the bubble higher should it continue to inflate.

Decision

Emerging market investments across the board have had a remarkable run from their lows in March of 2009 until the time of this writing at the middle of October 2009.

Therefore, based on the numbers I have collected and my analysis of current worldwide market conditions, my decision will be to buy EEM at this time. You may arrive at a different decision based on current data and your own analysis.

The Trading Plan

With my decision to buy EEM, I now need to create a trading plan. Here it is:

Purchase Price: $40. This is the current price market price as shown on the chart.

Trailing Stop: -$5. This order type and specification tells my online broker's system to automatically sell my position in EEM if the price drops by $5 from the highest price it reaches during the time I own it. Let me explain. If EEM immediately drops by $5 to $35, my initial stop-loss exit price, then my position is sold. The unique thing about a trailing stop, however, is that if the price of EEM goes up, the stop price goes up with it. But once it goes up, it never goes back down. So, if EEM goes to $45, the stop-loss price goes to $40, maintaining the $5 drop specification. If EEM then goes down to $42, the stop-loss stays at $40. If from there EEM goes to $48, the stop-loss goes up to $43. You can see that a trailing stop lets you lock in profits on the downside but allows profits to run on the upside! This is an amazing tool.

Take Profit Price: $45. Here I will elect to simply set an automated email alert at the take-profit price I have set. Any online broker should give you an "alerts" feature that allows you to do this. Now if EEM hits $45, I will get an email alerting me to this fact and I can look at the chart again. If I see the trend flattening out or turning down, I can sell all or part of my position to take profits. If, however, I think there is more room to grow, I can simply "tighten" my trailing stop without selling my position. I may decrease it from -$5 to -$3 for example. By doing this I lock in profit and can take advantage of further price increases that may still occur and with less risk. At the take-profit price, I may also elect to sell half of my position in EEM and leave the other half in place with a tighter stop.

Time Stop: 30 Days. As a final element of my trading plan I will make a note on my calendar that if neither of my exit prices is hit within 30 days, I will reexamine the price chart and tighten my exit prices. Or I may simply sell my position and reallocate money to other of my portfolio building blocks that are showing more promise. Otherwise, this is dead money and will not help me achieve my overall portfolio return goals.

Trading Plan Summary. This is my trading plan for EEM. I implement each element of it at the time of purchase. Two actions are all that are required. The first is placing a "buy order" with my online broker using a trailing stop where I specify the stop-loss dollar amount. The second action is setting a take-profit email alert. There is no trading commission associated with alerts.

Now I simply sit back and let the trading plan do its work. If the stop-loss condition is hit, my position is automatically sold and I will be notified of this action via email. If I get a take-profit email alert, I simply look at the chart and decide whether to sell my position or to tighten my trailing stop parameter and increase my take profit alert. If my time stop is hit, I either sell or tighten my exit points. This type of trading plan limits losses and lets profits run. It maximizes my potential for making money on each asset type that I buy for my target market segment. And you can see that the process requires very little of my time.

Allocating Money to the Agricultural Commodities Building Block

I now have completed my selection of target market building blocks and am prepared to determine allocations of my investment money to each. The process for doing this will be discussed in the next lesson of this course, Lesson 8.

The Current Portfolio

Taking into consideration the asset classes I decided to buy for the core segment of our developing portfolio, as discussed in Lesson 2, and the target market segment we started in Lesson 3, here is the current status of the portfolio I am building:

Asset Class	ETF	Allocation % (determined in Lesson 8)
Core Segment
Cash	Money Market Fund
Bonds	AGG
Stocks	SPY
Target Market Segment
Gold	GLD
Energy	XLE
Agricultural Commodities	EEM
Real Estate	VNQ (Watch List)	0%
Emerging Markets	EEM

Final allocations will be determined in Lesson 8.

Summary

In this lesson I have discussed adding an emerging markets component to the portfolio I am building in this education course. You learned what emerging markets are and some of the factors that affect the value of investing in this area. I selected four types of emerging market investments: single country, regional, international, and specific countries (e.g., BRIC). Then I found an ETF for each and collected relevant data to select the best candidate.

I then looked at a chart to determine if now is a good time to buy based on the direction of the price line. I also presented a sample analysis that took into account both short-term and long-term factors in deciding whether to include the selected ETF in my portfolio.

My decision was to buy EEM with a trading plan that enables me to participate in further increases in price while protecting me from a significant drop.

Preview of the Next Lesson

In Lesson 8, we will look at how to allocate our investment money among the various ETF portfolio building blocks selected throughout this course.

J. K. Lasser members are eligible to enroll in the National Association of Online Investor "Individual Investor Certification Program" at a significant discount. All students of this Lasser course may also enroll in the NAOI "Investing Basics and Creating Your Unique Plan" course for free. Click here for details.