Growth Emerges From Emerging-Market ETFs

iShares based on emerging markets have outpaced their developed-market counterparts.
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Maybe the "emerging" moniker should be dropped when it comes to emerging-market exchange-traded funds. Judging from recent fund flows and performance data, they most definitely have arrived.

According to ETF juggernaut Barclays Global Investors, demand for its international ETFs remained strong in January, continuing a pattern that started at the beginning of last year as higher returns abroad increased investors' appetite for global diversification. In particular, BGI's emerging-markets ETFs have shown no sign of a slowdown in 2006, with the funds outpacing those of developed foreign markets in both performance and flows in January.

BGI says the five international ETFs with biggest asset growth in January were all based on emerging markets: The

iShares MSCI Emerging Markets Index

(EEM) - Get Report

had 10.1% asset growth; the

iShares MSCI South Korea Index Fund

(EWY) - Get Report

, 21.9%;

iShares MSCI Taiwan Index Fund

(EWT) - Get Report

, 19.8%;

FTSE/Xinhua China 25 Index Fund

(FXI) - Get Report

, 21.8%; and

iShares MSCI Brazil Index Fund

(EWZ) - Get Report

, 21.2%.

The top two iShares representing developed foreign markets paled in comparison, with the

iShares MSCI EAFE Index Fund

(EFA) - Get Report

increasing assets by 0.47% and the

iShares MSCI Japan Index Fund

(EWJ) - Get Report

rising 1.8%.

At the end of January, U.S. ETF assets totaled $306 billion. BGI's iShares is the biggest ETF brand, with more than 100 funds and assets totaling $184 billion.

Money follows performance, as they say, because those emerging-markets ETFs had a great January in terms of price. The Brazil EWZ was up 24% for the month, China's FXI increased 16%, the emerging-markets EEM jumped 14%, Taiwan's EWT spiked 7.5%, and the South Korean EWY rose 6.7% for the month.

Back in the good old U.S.A., the

S&P 500

index rose 2.5% in January.

"It's not surprising that investors would be attracted to emerging-markets ETFs, because they have had a great run," says Dan Culloton, ETF analyst at Morningstar. "And not just single-country funds; even so-called diversified emerging-markets funds have hit the point where they are susceptible to a big stumble because they have been so hot for so long."

For those investors still weighing the decision to follow the pack into volatile emerging-market ETFs, it's worth pointing out that much of the outperformance in those ETFs can be attributed to strengthening currencies. The Korean won appreciated by 4.5% in January, reaching its highest level since 1997. The Brazilian real, boosted by rising commodity prices, strengthened by 5.2% against the U.S. dollar. BGI says it doesn't hedge currency in any of its ETFs.

Furthermore, investors piling into emerging-markets ETFs purely as a momentum play also should have a plan to get out, according to Sam Stovall, chief market strategist for S&P.

"Following the herd is the mantra of momentum investors, but the herd does not know the time to get out," says Stovall. "But if you are buying these ETFs for diversification, then be aware that these are volatile funds and not to be taken lightly."

But even without the boost from foreign-currency conversion, emerging-markets growth continues to merit attention from U.S. investors. According to a February report from J.P. Morgan, the 2006 gross domestic product growth forecast for emerging markets is 5.7%, nearly double the 2.9% expected from developed markets.

Broken down further, J.P. Morgan is looking for Latin America, Taiwan and Korea to grow GDP around 4.5% this year. China is expected to maintain its blistering pace with growth of 9.2% in 2006.

"There is a great danger in chasing performance," says Culloton, who suggests that skittish investors looking for international exposure look into global funds that not only hold emerging stocks but also have developed market international exposure. "Eventually, like all other stocks, they will revert to the mean."