The well-regarded stock market blog Investment Postcards in a recent post made the case for emerging markets being vulnerable to a near-term correction due to the very tight correlation to commodities and that commodities very recently have rolled over. Provided in the post is a very useful chart that clearly supports the thesis using the iShares MSCI Emerging Markets Index Fund ( EEM) as a proxy for the space. If you've been reading my articles over the last few years, you may recall my disdain for broad-based funds like EEM or the iShares MSCI EAFE Index Fund ( EFA). They tend to include large allocations to undesirable investment destinations and blend away the attributes of many of the superior component countries serving to increase the correlation of the fund to the U.S. market which in turn makes for an ineffective way to diversify. For investors who would rather not pick individual foreign stocks, I believe a better way to invest is with country funds. Obviously, countries like Brazil, which is one of the largest countries in EEM, is going to correlate very closely to most commodity indices, which over the longer term has been a good thing and is likely to continue to be an important exposure for many years to come. Commodity-based equity exposure should be one component of a foreign equity portfolio but so too should countries with no fundamental connection to commodities. One example would be the iShares MSCI Turkey Investable Market Index Fund ( TUR). Turkey has a large population (by European standards at 70 million), an average age in the low 20s, gross domestic product growth of 3.7%, and an inflation rate that is high at 8.6% but down considerably from its historical average. Turkey is a country that has become more important in the world economic order and will become all the more so if it is allowed to adopt the euro as its currency. The idea of a young population wanting to work in an evolving economy is easy to understand and the success of this theme can happen with no fundamental connection to commodities. Another example would be South Korea and the iShares MSCI South Koreas Index Fund ( EWY). Korea relies on exports of electronic components and automobiles, among other things, with little fundamental link to commodities. Obviously, South Korea has made a lot of news lately for the escalation of tensions with North Korea. If that is enough for you to want to avoid South Korea then that's another reason to avoid broad-based emerging markets funds as EEM has a 13% weighting in South Korea.
There are other examples of emerging markets with no fundamental link to commodities. These countries, like Turkey, have positive attributes, risk factors and can be extremely volatile at times. Other examples of low or no-commodity emerging country ETFs include iShares MSCI Israel Capped Investable Index Fund ( EIS), iShares MSCI Philippines Investable Market Index Fund ( EPHE) and iShares MSCI Taiwan Index Fund ( EWT). During short-term, even severe, downturns like 2008 it is unlikely that the market would discern between commodity-based countries and countries without commodity exposure. But over the course of an entire stock market cycle or even a decade, capturing the attributes of different types of countries should provide better diversification and a better risk-adjusted result. During the last decade just about all emerging markets did well. Looking ahead, should the run in commodities slow down or reverse some then countries not connected to commodities could perform better over the longer term as perceived consumers of commodities, like those already mentioned, could catch an extra tailwind from lower commodity prices.
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