EMERGING MARKET ETFs: IS THE HONEYMOON OVER?

The numbers are in, and they ain’t pretty!

Is the honeymoon over for investing in emerging market ETFs? Well, judging by what’s happened since the Fed’s May 10 decision to hike interest rates, you’d be forced to say yes.

One glance at the table below and you can see that the pain in emerging market ETFs has been gut wrenching. Look at just how deep the wounds have been in just the past two weeks:

The above figures are staggering. If this were a marriage it wouldn’t be a question of whether the honeymoon was over, it would only be a question of how much the divorce lawyers were being paid.

The logical question to ask is why are these emerging market ETFs getting slammed so hard? If you look at the actual markets in many of these countries, they are nowhere near as beaten up as the above ETFs.

On any given day, the reason for the disparity in performance between the actual country indexes and the ETFs has to do with the world trading environment.

Often what happens is that after foreign trading ceases for the day in the actual country-specific market, the ETFs tied to those specific countries begin to trade on the U.S. exchanges. Traders then react to the events of that market day in that specific country. What you often get is a disparity in the action, both pro and con, that either pushes the funds higher or sends them down faster than the actual underlying index.

For example, earlier this week the Brazil ETF (EWZ) was down nearly 8%, but the actual Brazil index was only down 3%. It was a similar situation this week in the Japan ETF (EWJ).

Right now there is a ton of money floating into emerging markets, as these markets have been on a huge run throughout most of 2006. In fact, according to the consulting firm of Financial Research Corp. in Boston, in the first quarter of 2006 investors poured $71 billion into shares of international and global funds. That represents two-thirds of the $105 billion in fund inflows to all long-term stock and bond funds, including ETFs.

It’s no surprise that with all of this money going into international funds, many of the volatile emerging market managers are scrambling to get orders filled and to square up positions in these funds. Often, that has the effect of either driving the price higher when stocks are climbing, or lower when stocks are getting hit hard. And because we’ve seen a worldwide selloff in the most heavily run up market sectors, e.g. the emerging markets, the selling right now has become particularly pronounced.

Your best defense right now, if you currently have exposure to any of these emerging market funds, is to take your profits and step aside. If you insist on clinging to these risky ETFs right here, then I implore you to at least set a stop-loss so that you don’t take a huge hit.

Remember that it is a lot easier to recover from several small losses than to have to try and recover from one really big loss. It’s those big losses that can be devastating to your net worth, and they should be avoided at all costs.

Be smart, set stop-losses, and if need be, take action!