What do you get into when you buy into an emerging market ETF? Many investors seem to assume that it’s more or less the same as a developed market tracker but with the prospect of faster growth and higher returns. But as our recent reviews of EM funds (available here and here) have shown, there are often some major differences.

To illustrate what might be considered to be typical investor expectations, let’s take the S&P 500. This is a fairly diverse and balanced benchmark, as you’d expect in the world’s largest and most liquid market. Sectors such as technology, financials, healthcare, consumer staples, energy, industrials and consumer discretionary each account for 10%-20% of the overall basket and reflect the US economy fairly well.

No single stock accounts for more than a few percent of the index. Few companies have significant shareholdings in each other and not many have a controlling shareholder. They’re run by professional management teams who are legally obliged to act in the best interests of all shareholders.

The picture is similar with European indices such as the FTSE100, the CAC40 or the DAX. They may not be quite so balanced and corporate culture does vary between countries, but broadly speaking an investor is buying into a basket of stocks that represents the overall economy. The companies are high quality businesses and investors can generally be confident of getting a fair deal.

But in emerging markets, the situation can be very different. The first thing that strikes you is how unrepresentative an EM ETF can be of the local economy. There are a handful of sectors that consistently have very high weightings out of all proportion to their importance. Typically, these are energy, mining and materials, financials, real estate and sometimes telecoms. The individual firms involved are generally extremely large compared to other companies.

Why is this? In emerging markets, firms in most sectors tend to be either relatively small or foreign-owned. Consequently, they’re underrepresented among listed companies. For example, much of Southeast Asia owes its rapid growth to manufacturing exports – yet this part of the economy barely features in the main market indices.

Meanwhile, firms in certain other sectors are much larger and more heavily represented. In some cases, this is because the company is a state-owned firm that has been partially privatised; these types of businesses are often enormous by local standards as a result of having previously been a monopoly or oligopoly. For example, Brazil’s Petrobras (oil) and Vale (mining) dominate the local stock market, each accounting for around 20% of the MSCI Brazil.

This is particularly relevant in a country such as China, where almost all the big firms are state-controlled. If you buy a tracker for the popular FTSE/Xinhua 25 benchmark, you get 45% financials, 20% telecoms, 10% oil and gas and 10% metals and mining – and every one of the firms involved is state-controlled.

Apart from the fact that weightings like this don’t reflect the underlying economy, investors should question whether these firms will act in the interests of minority shareholders.

In the case of Brazil, an investor might conclude that although the government still has a large stake in Petrobras, it is a high quality international oil company that will make most decisions on good commercial grounds. But at the other end of the scale, the enormous growth in lending at Chinese banks last year was dictated by government efforts to support the economy through the global downturn. Many of these loans will probably go bad. Who will pick up the bill if the banks need to replenish their capital? The indications are that it will be shareholders.

State-owned giants aren’t the only way in which the corporate sector can become unbalanced. In some countries with weak competition laws, individuals and families have built up strong positions in certain sectors (such as resources, utilities and infrastructure) that lend themselves to local monopolies.

The steady cashflow from a monopoly can be recycled into investments elsewhere, frequently real estate. This usually ends up as a web of listed companies; for example, Li Ka-shing, Hong Kong’s richest man, has nine separate listed businesses in his Cheung Kong Group and three of those are members of the 42-stock Hang Seng benchmark.

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