ETF Store Insight

Innovation on the Sector Front: Emerging Markets

June 10th, 2009 by Robert Dubois

Some investors allocate capital entirely along sector lines. Others use style and capitalization to specify asset allocations. Still others use a combination of the two, employing sector ETFs to overweight holdings within one or more sectors.

Prior to May 21 the universe of sector index ETF families numbered five covering U.S. equities, two covering international developed market equities (ex-US), and one covering global equities (including US). Conspicuously absent from the lineup was an emerging markets sector family.

For those that would employ sector ETFs to cover portions of international developed markets, the ability to allocate along sector lines may be equally important at the emerging markets level.

On May 21 Emerging Global Advisors (www.egshares.com) launched trading on two of a family of twelve ETFs to soon be trading. The ETF family will consist of ten sector ETFs, based on Dow Jones Emerging Sector Titans Indexes, one emerging markets “composite” and one emerging markets industry ETF, also based on Dow Jones emerging market indexes.

The DJ Emerging Markets Energy Titans Index Fund (EEO) and DJ Emerging Markets Metals & Mining Titans Index Fund (EMT) each cover 30 companies domiciled in thirteen and nine countries, respectively. 88% of Energy’s initial country allocation resides in Russia (36%), India (19%), China (16%), Brazil (10%) and South Africa (7%). For Metals & Mining, the top 5 country holdings, representing 94% of the total, include South Africa (31%), Brazil (23%), China (16%), Russia (13%) and India (10%). Company weightings are based on float-adjusted market capitalization and are capped at 10% with adjustment quarterly.

So what might the new emerging markets sector family mean to investors?

Investors using entirely style and capitalization-based allocation disciplines allow sector concentrations to migrate as economic conditions evolve and the business cycle marches on. For those preferring to overweight certain sectors, they soon will be able to do so at the emerging markets level, rather than only at the U.S. and developed market international levels.

For sector allocation investors, the same sector strategy framework one might apply to U.S. and international developed markets will now be possible at the emerging markets level. For sector allocators in international developed and emerging markets, control of sector exposure is the primary allocation objective, with country, capitalization and style distribution remaining migratory in nature. Individual countries tend to have distinct industry concentrations. Purchase of an ETF covering the U.K., for example, would find energy/petroleum and banking to figure prominently in the holdings. Likewise, an ETF covering Switzerland would be expected to have a heavy proportion of holdings in banking and insurance industries. Prior to the roll-out of the emerging markets sector family, sector allocation practitioners had to attack allocation needs to emerging markets through regional, country-specific or thematic alternatives (e.g., BRIC, Chindia) alone.

Emerging Global Advisors indicated that institutional investors constitute the primary target audience for the family of emerging markets sector ETFs. And, apart from tactical plays involving up to only a few of the family at any given time, that’s quite understandable. A challenge for sector-based allocators is to cover the equities landscape with as many as thirty sector holdings (10 U.S., 10 international developed markets, 10 emerging markets). Perhaps the next big innovation step for sponsors of families of sector-based ETF will be to create a single ETF which holds each of the sectors in a prescribed concentration (equal weight or another, relatively agnostic, proportion). This will then allow any “overweighting” to be done with one, two or three of the individual sector pieces – thereby enabling the use of a sector-based approach with one-to-four holdings rather than 10 for each of the equity asset areas (U.S., international developed markets, emerging markets).

Look for this family of ETFs to stick around. Creation of the emerging market sector ETF family addresses specific strategy needs for a meaningful, if minority, slice of the investment community.