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Emerging Markets iShares Begin Trading

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The iShares MSCI Emerging Markets began trading today on the American Stock Exchange under the ticker EEM. The new exchange-traded fund, managed by Barclays Global Investors, is benchmarked to the MSCI Emerging Markets Free (EMF) index.

The fund will use a representative sampling strategy to approximate index performance, and plans to hold approximately 200 local securities, American Depositary Receipts (ADRs), and Global Depositary Receipts (GDRs) to provide exposure to 20 equity markets.

We spoke with Feng Ding, senior portfolio manager in the international equity portfolio management group at BGI, prior to the launch. She is currently in charge of the international iShares team, which manages 33 single-country, regional, global, and sector iShares across the MSCI international and S&P global indices.

Q: How do the emerging markets iShares stack up to comparable funds in terms of expenses?

A: The average expense ratio of the funds in Morningstar's emerging markets category is 2.12%, while the iShares are set at 0.75%. But there are other cost advantages as well, especially in terms of turnover. Turnover is an important point in emerging markets because this asset class has higher transaction costs. Higher turnover translates into higher implicit costs that negatively impact performance. According to Mornigstar, the average emerging market fund turnover [as of December 2002] was 104%, which is very high in our opinion. To give you a sense of the index turnover, the MSCI Emerging Market Free index turnover is 16%.

Q: What's the case for holding emerging markets in a portfolio, and how do emerging markets correlate with domestic stocks?

A: In terms of strategic asset allocation, people look at emerging markets as a way to gain exposure to economic growth and opportunities outside the U.S. and other developed markets. The second reason is to either provide enhanced returns or risk diversification in the portfolio.

Emerging markets make up about 20% of the world's Gross Domestic Product (GDP), a rather significant portion. Also, based on the GDP growth figures for 2001, 14 of the 16 fastest-growing economies were in emerging markets.

The risk diversification benefits of emerging markets really come from reasonably low correlation with both the U.S. and developed markets. The correlation vs. the U.S. using the Russell 3000 is about 0.60; the correlation of the MSCI EMF index vs. the MSCI EAFE is about 0.54. On average, we see our institutional clients allocate roughly 5% to 10% of assets to emerging markets.

Q: How are emerging markets currently valued relative to historical levels?

A: Emerging markets are currently at a pretty decent discount relative to the U.S. and developed markets. They have the highest yield of these three asset classes, and the lowest price-to-earnings (p/e) ratio.

Looking at historical valuations of emerging markets, the p/e is probably at its lowest point in five years. Generally speaking, emerging markets are viewed as a good asset class to gain exposure to any upswings in the global economy.

Q: How have active managers of emerging markets funds fared against the MSCI EMF index?

A: We looked at the relative performance of funds in Morningstar's emerging markets category vs. the index. For the period ending December 2002, the median emerging markets fund has underperformed the MSCI EMF index when you look at 1-, 3-, 5-, and 10-year returns. I think that speaks to the fact that the underlying country volatility is very high for emerging markets. Market timing and asset allocation between countries are difficult to capture, and higher turnover translates directly into higher transaction costs.