U.S. Investors poured a stunning $54 billion into emerging-market exchange-traded funds (ETFs) in 2012, according to research firm ETFGI. That's a stunning growth from just $3 billion in 2011. The two largest ETFs in the category, Vanguard FTSE Emerging Markets ETF (NYSE: VWO) and the iShares MSCI Emerging Markets Index (NYSE: EEM) now have a hefty $125 billion in assets under management. Many investors have moved beyond those catch-all funds, and are now focusing on country-specific ETFs such as the iShares FTSE China 25 Index Fund (NYSE: FXI) or the iShares MSCI Brazil Index (NYSE: EWZ). But many still don't know about the two most important factors that will affect their returns.

I'm talking about currency and inflation.

The Nikkei's blunted rally
While Washington was mired in year-end talks over the "Fiscal Cliff," Japanese investors were breaking out the champagne. A new government in Tokyo, promising to provide a major stimulative boost to the economy, kicked off a major stock rally.



But U.S. investors who had the foresight to invest in Japan aren't quite so happy. Since the start of November 2012, the Japanese yen has weakened, from 79 yen to the dollar to a recent 89.3. The yen's 13% depreciation has offset some of the Japanese stock market's gains, meaning U.S. investors have failed to fully prosper from the rally.

However, it works both ways. A number of economists say the rally in the yen has come too quickly, aided by short-covering by investors who were betting against the dollar. These economists say the yen will restrengthen in coming weeks, which means that an ETF such as the MAXIS Nikkei 225 Index (NYSE: NKY) will likely get a lift from the currency reversal. The key takeaway is to steer clear of any country-specific ETFs if you think the country's currency is too strong and due for a drop. (Indeed, the Japanese yen had been trading near all-time highs against the dollar until the recent pullback).

The inflation bug
Japan's economy is quite advanced, and on par with our own. As a result, inflationary concerns are nearly non-existent at the moment, as is the case in Europe and the United States. But in more dynamic emerging economies, inflation is an ever-present threat.

Nearly two years ago, I extolled the virtues of Vietnam and recommended the Vietnam Fund (NYSE: VNM) as a solid investment choice.

Soon thereafter, the Vietnamese economy started to choke on its own growth, as bottleneck pressures led to rising inflation. Here's the problem with inflation: It forces government to take a series of punitive measures to slow the economy to help reduce inflationary pressures. Vietnamese inflation figures are now starting to trend lower, which helps explain why the Vietnamese ETF has begun to rally.



Back in 2011, I looked at India as well, noting that :"years of steady growth -- 14.4% annually in the past decade -- have created choke-points in the economy where the roads, bridges and rail lines simply can't keep up with the rising level of economic activity."



Fast forward to 2013, an India finally appears to have inflation under better control. As The Wall Street Journal recently reported, India's inflation rate has slowed to its lowest level in three years. A slowing economy gets some of the credit, as do several key investments in infrastructure in major cities that have removed some bottlenecks.

The drop in inflation is expected to lead to government policies that augment economic growth (whereas the Indian government had sought to slow the economy while inflation was rising). As a result, the Indian economy looks set to rebound in 2013 and 2014, making for a more timely entry point for this fund.

Risks to Consider: Investors are pouring into emerging-market funds, but they will need to have a strong stomach. These funds can quickly lose steam if the U.S. market stumbles, which is why you need a multi-year time horizon with your emerging market investments.

Action to Take --> Whenever you are assessing emerging markets, you must spend time analyzing the country's currency and inflation pressures. An already-weak currency and a benign inflation backdrop, are two key positives you want to look for.

Related Articles
  1. Chart Advisor

    3 Ways to Trade the Rising Volatility

    With volatility increasing in the markets, many are turning to these three volatility-capturing exchange-traded products.
  2. Mutual Funds & ETFs

    ETF Analysis: iShares US Basic Materials

    Learn about the iShares US Basic Materials exchange-traded fund, which invests in the equities of chemicals, metals and industrial gas companies.
  3. Mutual Funds & ETFs

    ETF Analysis: Ultra Oil & Gas

    Find out more about the ProShares Ultra Oil & Gas exchange-traded fund, the characteristics of the ETF and the suitability and recommendations for the fund.
  4. Mutual Funds & ETFs

    ETF Analysis: PowerShares DB Commodity Tracking

    Find out about the PowerShares DB Commodity Tracking ETF, and explore a detailed analysis of the fund that tracks 14 distinct commodities using futures contracts.
  5. Mutual Funds & ETFs

    ETF Analysis: PowerShares FTSE RAFI US 1000

    Find out about the PowerShares FTSE RAFI U.S. 1000 ETF, and explore detailed analysis of the fund that invests in undervalued stocks.
  6. Mutual Funds & ETFs

    Comparing ETFs Vs. Mutual Funds For Tax Efficiency

    Explore a comparison of mutual funds and exchange-traded funds, or ETFs, and learn what makes ETFs a significantly more tax-efficient investment.
  7. Mutual Funds & ETFs

    ETF Analysis: Vanguard Small-Cap Value

    Find out about the Vanguard Small-Cap Value ETF, and explore detailed analysis of its characteristics, suitability, recommendations and historical statistics.
  8. Mutual Funds & ETFs

    ETF Analysis: Vanguard Intermediate-Term Corp Bd

    Learn about the Vanguard Intermediate-Term Corporate Bond ETF, and explore detailed analysis of the fund's characteristics, risks and historical statistics.
  9. Insurance

    Whole or Term Life Insurance: Which Is Better?

    Learn the difference between term life insurance and whole life insurance. Understand when it is beneficial to buy each type of life insurance.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares 10-20 Year Treasury Bond

    Learn about the iShares 1-20 Year Treasury Bond ETF and its holdings, and understand why investors may be better served to look at other bond funds.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  3. Exchange-Traded Mutual Funds (ETMF)

    Investopedia explains the definition of exchange-traded mutual ...
  4. Fractal Markets Hypothesis (FMH)

    An alternative investment theory to Efficient Market Hypothesis ...
  5. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  6. Sucker Yield

    When an investor has essentially risked all of his capital for ...
RELATED FAQS
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  5. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  6. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!