By Palash R.

Ghosh

Profit and Peril in Emerging Markets

Attracted by surging stocks in some developing countries? Make a point not to put all
your eggs in one basket
Stocks in the emerging markets continue to soar, as investors, turned off by tepid returns from the
U.S. and other developed economies, are increasingly attracted to these regions. Year-to-date
through Oct. 5, $14.8 billion in new cash entered emerging-markets equity funds, vs. an inflow of
$2.8 billion for all of 2004, according to EmergingPortfolio.com.

Moreover, after a few years of consistently strong performance -- much of it driven by high
commodity prices -- many emerging markets remain attractively valued relative to those of the
U.S. and Western Europe.

For example, as of Sept. 30, based on 12-month trailing p-e, emerging market stalwart Brazil still
trades at a modest 10.7, according to data from S&P/Citigroup Global Equity Indices. Similarly,
Malaysia trades at only 12.3, while Mexico is priced at just 8.3. As a whole, the emerging markets
trade at about 13.3, while U.S. equities trade at 21.0.

For investors seeking to cash in on these climbing markets, exchange-traded funds (ETFs)
provide an appealing alternative to mutual funds because of their transparency and much lower
expenses. Standard & Poor's FundAdvisor identified 14 ETFs that invest exclusively in emerging-
markets equities. Most, however, invest in a single country, and can court significantly more
market and political risk.

CHINA PLAYS. Like the markets they seek to mimic, emerging markets ETFs come in all shapes
and sizes. Some so-called "emerging markets," like South Korea, could arguably be considered
"developed," given their diversified economies, relatively stable political structures, and
sophisticated market establishments.

Nations classified as truly "emerging," like China, are at a relatively early stage of their economic
development, operating under either unstable political leadership or governments that have as yet
resisted free, open-market economic philosophies. Such countries are typically dominated by one
or two industries, and their stock markets are often illiquid and subject to wild swings.

Due to its insatiable appetite for foreign commodities and enormous potential, China has become
the world's economic growth engine. However, it remains difficult -- if not impossible -- for non-
Chinese investors to participate directly in these markets. One convenient alternative is iShares
FTSE/Xinhua China 25 Index Fund (FXI ), which invests in the largest, most-liquid China-based
companies trading on the well-established Hong Kong Stock Exchange.

However, there are a few things to consider before investing here. Despite China's promise, a
very concentrated portfolio coupled with the country's growing pains can likely spell high volatility
for this ETF. Investors must deal with a host of issues associated with investing in China, still a
communist country. These range from corporate governance to the evenness of China's
expansion, which is likely to experience periods of booms and busts.

THREE TO WATCH. Outside of China, an emerging market that Western investors tend to
overlook is Malaysia, a relatively stable and prosperous Southeast Asian powerhouse with an
educated workforce and strong export partners that include China. With 79 holdings, the iShares
MSCI Malaysia Index Fund (EWM ) provides good sector diversification. Reflecting the nation's
maturing industrial landscape, the fund invests in a number of sectors. Banks account for the
largest slice (22.6%), followed by food, beverage, & tobacco (11.2%), consumer services (11.2%),
utilities (10.7%), transportation (9.6%) and telecommunication services (9.1%).

South Africa is another emerging market that offers some diversification. Although the country is
famous for its mining industry, that's only part of the story. Materials, at 19.5%, indeed represents
the top sector of the iShares MSCI South Africa Index Fund (EZA ). But this ETF portfolio also
has exposure to banks (14.7%), energy (13.7%), insurance (10.8%), and telecommunication
services (9.8%).

In recent years, Brazil has been among the world's most explosive markets, but investors must
remember that this economy is dominated by just two sectors, materials and energy. These two
industries alone currently account for 54.3% of the iShares MSCI Brazil Index Fund (EWZ ).

Moreover, Brazil's political system seems to wallow in perpetual chaos, adding still more risk to
the equation. Still, with oil prices high and commodity sales to China robust, Brazil may continue
to deliver strong returns. Indeed, foreign investors have given Brazil their vote of confidence by
pouring cash into its markets.

WIDER APPROACHES. For investors who are enamored with Latin America but don't want to put
all their eggs in one basket, the iShares S&P Latin America 40 Index Fund (ILF ) is a better
option. This ETF invests in four countries -- Brazil, Mexico, Chile, and Argentina -- with the first
two nations representing the lion's share of assets (86.9%). This fund also offers somewhat better
sector diversification than the single-country Brazil and Mexico ETFs. Top sectors comprise
materials (29.0%), telecommunication services (20.2%), energy (14.3%) financials (14.2%), and
consumer staples (11.7%). Still, it poses a lot of region-specific risk since Latin America
represents just one emerging market.

ETFs that invest broadly in emerging markets even better minimize country, industry-specific,
market, and currency risk. For example, iShares MSCI Emerging Markets Index Fund's (EEM )
top country allocations include Korea (16.8%), South Africa (12.5%), Brazil (11.0%), Taiwan
(10.6%), and China (7.8%). This ETF also provides exposure to under-represented emerging
economies such as India (5.3%) and Thailand (2.9%). Industries are virtually evenly spread in this
portfolio. The top five sectors comprise energy (15.0%), banks (14.9%), telecommunication
services (14.2%), materials (13.8%), and semiconductors (13.2%). With 265 holdings currently,
this emerging markets ETF has very broad diversification.

Vanguard Emerging Markets VIPERS (VWO ), which tracks the MSCI Select Emerging Markets
Free Index, counts Korea (19.7%), Taiwan (16%), Brazil (12.2%), South Africa (11.9%), and
Mexico (6.9%) as it largest country holdings.

SMALL BET. Another vehicle for broader exposure to the emerging markets comes from the
BLDRS Emerging Markets 50 ADR Index Fund (ADRE ), which is, strictly speaking, not an ETF
but a unit investment trust. This portfolio invests in American Depositary Shares (ADRs) of foreign
companies that trade on U.S. exchanges, giving investors the benefits and comfort of buying
stocks directly on familiar boards. While Brazil, China, Taiwan, and Korea represent the top
country allocations, BLDRS Emerging Markets 50 ADR Index also has exposure to India.

The BLDRS Asia 50 ADR Index Fund (ADRA ) has limited exposure to the emerging markets,
since it's dominated by Japan and Australia (78.6% of assets). However, this fund may be
attractive to investors who want just a small allocation to emerging economies such as China and
India.

S&P index strategist Srikant Dash says he expects more ETF products focused on the emerging
markets to become available. However, they will likely feature the smaller "new frontier" segments
of these markets.

EASTERN EXPOSURE. "In the last 10 to 15 years, large emerging markets such as Mexico,
Taiwan, and Korea -- which make up 50% or more of most broad emerging market indexes --
have become increasingly correlated with the developed markets," Dash says. "This is because
companies in these nations are becoming increasingly involved in the global supply chain. As a
result, their fortunes are more closely blended with the fortunes of U.S. companies.
Consequently, the broad emerging market indexes have lost a little bit of their diversification
benefits."

Dash says the next wave of ETF product innovation will likely be dedicated to emerging markets
such as those in Eastern Europe, including Poland and the Czech Republic. "These economies
are in the position that Korea and Taiwan were 20 to 30 years ago," he says. "They're less
correlated to the U.S., and would provide the investor with the diversification that makes investing
in the emerging markets so appealing."

Another part of the emerging world that hasn't been tapped yet -- Africa -- may start to appear in
ETF products, Dash says. "For example, there are large billion-dollar resource companies in
African nations like Ghana, as well as South Africa," he says. "There are gold, diamond, platinum
companies, many of which trade on the London and South African exchanges." To address
liquidity issues in such markets, Dash notes, the ETF industry will probably "find a way to
structure liquid baskets of stocks from these less correlated markets."

PROS ONLY. Another hot trend that the ETF industry may capitalize on is BRIC -- Brazil-Russia-
India-China. "These are the largest countries in the emerging world, with fast-growth trajectories,"
Dash says. "We may see some ETF products that invest exclusively in these four nations as
well."

Because of their increased risk, single-country ETFs are only appropriate for sophisticated
investors, active traders, and institutional investors who take positions based on macroeconomic
calls -- they aren't suitable the balanced portfolio of an individual investor, Dash cautions. "Long-
term investors may keep a small portion, perhaps 5% to 10% of the equity portion of their overall
portfolio, in one of the broader emerging markets ETFs."

Here are some emerging markets ETFs, with their one-year returns through Sept. 30, assets, and
expense ratios.

EMERGING MARKETS ETFS

One-Year
Net Return Expense
ETF Assets (%) Ratio (%) Inception
Broad-Based
BLDRS Emerging $234.0 53.9 0.3 Nov. 2002
Markets 50 ADR Index million
Fund (ADRE)
iShares MSCI $8.19 49.7 0.75 Apr. 2003
Emerging Markets billion
Index Fund (EEM)
iShares S&P Latin $850.0 82.8 0.5 Oct. 2001
America 40 Index million
Fund (ILF)
Vanguard Emerging $351.4 N.A. 0.3 Mar. 2005
Markets VIPERS million
(VWO)
Single-Country
iShares FTSE/Xinhua $1.27 N.A. 0.74 Oct. 2004
China 25 Index Fund billion
(FXI)
iShares MSCI Brazil $828.3 83.8 0.74 July 2000
Index Fund (EWZ) million
iShares MSCI Hong $638.4 23.6 0.59 Mar. 1996
Kong Index Fund million
(EWH)
iShares MSCI $414.7 11.3 0.59 Mar. 1996
Malaysia Index Fund million
(EWM)
iShares MSCI Mexico $298.0 61.9 0.59 Mar. 1996
Index Fund (EWW) million
iShares MSCI $386.3 19.3 0.59 Mar. 1996
Singapore Index million
(EWS)
iShares MSCI South $169.8 43.9 0.74 Feb.
Africa Index (EZA) million 2003
iShares MSCI South $828.4 55.4 0.74 May 2000
Korea Index Fund million
(EWY)
iShares MSCI Taiwan $746.2 9.9 0.74 June
Index Fund (EWT) million 2000
PowerShares Golden $66.9 N.A. 0.6 Dec.
Dragon Halter USX million 2004
China Portfolio (PGJ)