Returns from shares in emerging markets have been weak since the global financial crisis; the iShares MSCI Emerging Markets ETF (ASX: IEM) has a 5-year average annual return of 1.1%, and 1.48% over 10 years.

As the ETF does not use currency hedging, Australian investors are exposed to movements in the underlying currencies. This means the weak Australian dollar has cushioned investors from some of the poor performance – by comparison, the USD version of the same ETF has had an average annual return of -4.71% for the last 5 years.

Much like the Australian market, emerging markets have been hurt by soft commodity prices and a slowdown in China. The following chart shows how closely the ETF of emerging markets has tracked with the S&P/ASX 200 (Index:^AXJO) (ASX:XJO), with both underperforming the iShares Core S&P 500 ETF (ASX: IVV) considerably.

ETF

Source: Google Finance

Allocations within emerging markets funds vary, however China usually represents the largest exposure. IEM is also currently invested in South Korea, Taiwan, India, South Africa, Brazil, Mexico, Russia, Malaysia, and Indonesia. Major positions include companies such as Samsung Electronics, Taiwan Semiconductors, Tencent Holdings, China Mobile, and Alibaba Group.

Investors can gain similar exposure through the SPDR S&P Emerging Markets Fund (ASX: WEMG) or the Vanguard FTSE Emerging Markets Shares ETF (ASX: VGE).

Time to buy?

An asset class with significant underperformance is likely to represent a good opportunity sooner or later.

Bloomberg recently reported that Blackrock Inc., Franklin Templeton and Goldman Sachs are each bullish on emerging markets. In addition, Research Affiliates considers that emerging markets are quite possibly the ‘trade of the decade’.

The cycle-adjusted P/E ratio is a method of valuation which compares average earnings over a number of years (usually 10) to the current price. This metric has been shown to be a useful indicator of returns over the next 5-10 years. The Wall Street Journal recently published an interesting article showing the ratio for emerging markets over time, relative to the US and Europe:

ETF2

Research Affiliates calculated that 5-year returns have previously averaged 188% for emerging markets when the cycle-adjusted P/E ratio has reached current levels.

It is important to note that many analysts have been making the case that emerging markets are cheap for several years.

However, something that is cheap can always get cheaper. Emerging markets ETFs are likely to be volatile and are best suited to a patient long term investor as part of a well-diversified portfolio.

As an example of how an allocation to emerging markets might be used – the Vanguard LifeStrategy Balanced Fund targets a 2.5% allocation to emerging markets; the Growth fund targets 3.5%, and the High Growth fund aims to have exposure of 4.5%.

It would also make sense to mix your exposure with 3 of the Blue Chip Shares on the ASX

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Motley Fool contributor Matthew Bugden holds shares in the iShares MSCI Emerging Markets ETF. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.