Consider a new approach to emerging-markets investing

To tap into the potential of some of the world's fastest-growing economies, investors need to look beyond the broad emerging-markets categories and start paying attention to the specific sectors and industries that actually drive performance. The best way to do this is through a surge of new pure-play exchange-traded funds, where everything is becoming more nuanced, while traditional, broad-market exposure is almost old-school. “The older, original emerging-markets ETFs were just designed to provide exposure, but the new indexes coming out now are designed to capitalize on opportunities,” said Christian Magoon, an independent ETF industry consultant. For an example of what is unfolding, consider China, where early and easy exposure to the country's economic growth was gained through the iShares FTSE/Xinhua China 25 Index (FXI), offered by Barclays Global Investors. That ETF was created in 2004 with an emphasis on liquidity, which is why the index today has a 46% weighting in financial stocks but almost no exposure to those sectors most responsible for driving the country's fast-growing economy. If anything, China is an infrastructure growth story, yet the ETF has less than a 9% weighting in industrial stocks, 1.6% in consumer stocks and has no exposure to technology companies. Thanks to the rapid evolution of the ETF universe, there are now ways to gain more-direct exposure to hot sectors within most emerging markets. Exposure to China's infrastructure can be gained through the Emerging Global Shares INDXX China Infrastructure Index Fund (CHXX), launched last month by Emerging Global Advisors LLC. In December, Global X Management Co. LLC started offering exposure to the consumer sector with the Global X China Consumer Fund (CHIQ). And exposure to China's tech sector can be gained through Claymore China Technology (CQQQ), launched in January by Claymore Securities Inc. It is clearly more aggressive and requires more due diligence on the underlying market drivers, but slicing and dicing these markets is the best way to gain the diversification benefits of the emerging markets. “As the emerging markets continue to join the globalized world, they trade like the rest of the world,” said Richard Kang, chief investment officer at Emerging Global Advisors. He cited the performance of a popular, broad emerging-markets ETF as an example of how correlation is spreading across the global markets. The iShares Emerging Markets Index (EEM) gained more than 60% in 2009, more than double the S&P 500's gain for the year. But this year through March 2, the ETF was down 3.4%, while the S&P 500 was flat. The point, according to Mr. Kang, is that the “broad emerging markets are starting to look like a levered play on the S&P 500, and they are no longer providing investors with the kind of diversification they might be looking for in the emerging markets.” Clearly, he has a dog in this fight, but that doesn't nullify the validity of his argument. What has been unfolding in the emerging-markets-ETF arena over the past several months has already been applied to developed markets by companies such as State Street Global Advisors, which offers the Select Sector SPDR ETFs for several developed markets, including the United States. And that trend continues. PowerShares Capital Management LLC recently registered to launch a series of ETFs that will become small-cap versions of the S&P 500 sectors. The idea of carving out more-concentrated exposure by sector or market capitalization, particularly in emerging markets, does come with a whopper of a trade-off in the form of increased volatility. But concentrating exposure might also help investors avoid certain country risks that are often overlooked. For example, with Van Eck Global's Market Vectors Russia ETF (RSX), investors benefit from a 34% weighting in the country's booming oil and gas industry. But the ETF also includes two-thirds of everything else in Russia, plus a 100% exposure to the increasingly unpredictable Prime Minister Vladimir Putin. Investors could gain the same one-third exposure to Russia's oil and gas industry, combined with a two-thirds weighting in other emerging-markets oil and gas stocks, through the Emerging Global Shares Dow Jones Emerging Markets Energy Titans (EEO), which Emerging Global Advisors launched in June. “The more slicing you do by sector and market cap, the more you increase risk and volatility in some already volatile markets,” Mr. Magoon said. “But I think we'll continue to see countries sorted out this way, because investors are searching for more-focused opportunities.” Questions, observations, stock tips? E-mail Jeff Benjamin at -jbenjamin@investmentnews.com.