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Is now the time to profit from emerging-market falls?

Emerging-market investment may seem seem appealing to investors keen to diversify their portfolio and get exposure to some of the world’s fast-growing economic regions like Asia or Latin America, where it’s not uncommon for countries to have GDP growth of 5%-7%, triple that or more of many developed nations.

Acronyms have been invented to group together emerging nations, the BRICs, Brazil, Russia, India and China and now the MINTs, Mexico, India, Nigeria and Turkey. These acronyms are not much more than marketing gimmicks to attract investors’ attention, but that’s not to say emerging-market investments cannot pay off.

For interested Australian investors it’s almost impossible to invest relatively small amounts directly into equities listed on these countries stock exchanges. There are often regulatory and administrative hurdles too high for small investors to negotiate.

One easy way to gain exposure is through buying exchange traded funds (ETFs) that are listed on the ASX and possible to buy just like an ordinary equity. One of the biggest emerging-market ETFs is the iShares Emerging Markets ETF (ASX: IEM). Other iShares funds available on the ASX include the iShares MSCI BRIC ETF  (ASX: IBK) and iShares China Large-Cap ETF (ASX: IZZ).

The iShares Emerging Markets ETF aims to track the performance of the MSCI Emerging Markets Index, which is designed to measure emerging-market equity performance on a very broad basis. The ETF’s underlying holdings consist of investments in leading Chinese, South Korean, Taiwanese, Brazilian, South African, Indian, Russian and Mexican companies, among others, totalling investments in 21 emerging nations.

Some of the more well-known companies include Korea’s finest, Samsung Electronics Co and Hyundai Motor Company.  There’s also Russian energy-giant Gazprom OAO and Chinese technology-titan China Mobile Ltd. You don’t need to be an investment genius to see that companies held are primarily operating in mega-markets with large and young populations enjoying rising disposable incomes. In total, the ETF has an interest in more than 800 different companies across the emerging-market universe.

Under the ETF’s prospectus distributions are not guaranteed, but it does have a consistent track record of paying out income earned two or three times a year. The estimated trailing yield over the last 12-month period is 2.15%.

The ETF is priced and distributions made in U.S dollars. Therefore investors who think the tapering of the U.S Federal Reserve’s bond-buying program will support the greenback’s appreciation over the Australian dollar would do well to invest now, to take advantage of a lower Aussie dollar when exchanging back in the future.

Indeed, commentators have opined that the Fed’s tapering has encouraged investors to bring money back from emerging markets to its U.S source; in order to avoid the downstream risks of increased emerging-market volatility, particularly around currency devaluations. This is what contributed to the recent heavy falls across emerging markets, with the ETF’s price falling about 10% from its November pre-taper high of $46.42.

Given the potential for capital gains alongside income and a significant exchange rate profit the investment case may seem seductive.

Risks and costs are significant though, both tangible and intangible. Tangible costs include management fees and expenses of 0.67% per year as a direct overhead, in addition to any effective spread applied every time you sell or buy into the fund. A typical buy-sell spread for an investment fund may add 0.30% to your purchase price and deduct 0.30% from your redeemed proceeds.

The management fee of 0.67% is relatively low when compared to investing in an actively managed emerging-market fund offered by a typical fund manager, where costs can easily be triple that. You’ll also have to pay your standard one-off brokerage fee, just like buying an equity.

Other risks of emerging-market investing are many and plain for all to see, they include political and economic volatility, dubious corporate governance practices, runaway inflation and crashing currencies wreaking economic Armageddon. Nations currently exhibiting symptoms of these risks include Thailand, Turkey, Ukraine and Argentina, among others.

Foolish takeaway

Every investor must decide whether they are prepared to take on these risks, and no serious (or sane) investor would allocate more than a very small proportion of their available capital to emerging markets, even with the diversified benefits of an index-tracking ETF such as those offered by iShares.

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Motley Fool contributor Tom Richardson has no financial interest in any company mentioned in this article. You can find him on twitter @tommyr345

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