Of course they’re more volatile than rival iShares and SPDRs. But international sector ETFs focused on developing markets can help diversify portfolios, say firm’s managers.

Bob Holderith is chief executive of Emerging Global Advisors. Richard Kang is chief investment officer for the New York-based company, which recently launched the first exchange-traded funds focused on specific sectors in emerging markets. (See related story here.)

EGA is expected to launch soon a third ETF that will act as a composite of the 10 underlying sectors in the Dow Jones emerging markets indexing series it’s using for current and upcoming funds.

The company says that nine more are in the works focusing on emerging markets sectors. Those will join the May launches of the EGS Emerging Markets Energy Fund (NYSE Arca: EEO) and the  EGS Emerging Markets Metals & Mining Fund (NYSE Arca: EMT).

IndexUniverse.com’s Murray Coleman caught up with Holderith and Kang late Thursday to discuss the future of sector investing in developing markets.

IU: What is available for U.S.-based investors in terms of foreign sector ETFs now?

Holderith: The family of Select Sector SPDRs is the dominant ETF line providing sector-based exposures.  They’ve got a long history. But those ETFs only focus on U.S. companies. For pure international exposure to foreign sectors, we’ve only seen two-  to three- years worth of actual performance history. And that’s through the iShares’ global sector family of funds as well as those of State Street Global Advisors. The SSgA  family is purely international sector ETFs.

IU: Then your firm’s line-up of international sector ETFs will compete most directly against those of SSgA?

Kang: No, since the SSgA ETFs are focused predominately on developed markets. For example, take the SPDR S&P International Financial Sector (NYSE: IPF). The top weighted countries are (in order): Japan, Canada, Australia, the U.K., Spain and Switzerland. The SSgA international sector ETFs do allow for some emerging markets exposure. But as cap-weighted indexes, they’re heavily skewed to developed countries.

IU: Why is your company going with pure emerging markets exposure rather than a mix of developed and emerging markets?

Holderith: There’s more than enough coverage of developed international markets now in the ETF marketplace. In terms of emerging markets, we’ve seen broad, regional and country specific funds. But we’re first to market with sector-specific ETFs for developing countries. The EMT and EEO ETFs are the first of a series we’re preparing to launch.

IU: What others are planned?

Holderith: We’ve got in the pipeline 10 ETFs still left to bring-to-market. Those will all use Dow Jones indexes, similar to those used by EMT and EEO. Dow Jones uses a classification system for sectors called the ICB (or industry classification benchmark) system. The other sector-specific ETFs in various stages of planning we’re working on launching cover: basic materials; consumer goods; consumer services; financials; health care; industrials; technology; telecom and utilities.

IU: You’ve also got a broader ETF that has received regulatory approval, don’t you?

Holderith: Yes, we’ve got a composite ETF that’s due to launch within the next few weeks.  That’s an ETF tracking a Dow Jones index that takes the top 10 names from each of the 10 major emerging markets sectors. (It won’t include metals and mining, which is a subsector of basic materials.)  So that will leave 100 names in the underlying composite index. And as in all of our ETFs, we have a rule that caps individual weightings at no more than 10%.

IU: In the composite index for such an emerging markets fund, what would the sector weightings look like then?

Holderith: Oil and gas along with financials are the dominant sectors in the composite index.

IU: What type of performance have you seen through back-tested data for emerging markets sector indexes compared to developed markets sector indexes?

Kang: We have data going back many years for the underlying benchmarks. The data for emerging markets, however, isn’t as robust as that for developed markets. So we really focus on data going back to December 2005 when comparing the Dow Jones composite benchmark we’re using for our emerging markets sector funds.

IU: What do those comparisons show?

Kang: Going back to 2005, returns were generally spectacular up through 2007 for emerging markets vs. developed markets. In the latter half of 2008, we saw greater volatility and bigger losses in emerging markets. As with any more volatile asset class, emerging markets offers the potential for greater long-term gains as a result. Clearly, some sectors performed better in relative terms during the periods when markets were going up versus others.  The same is true in the bear market of 2008.  That is the essence of the popularity of sector funds — their selection during different stages of the market cycle.

IU: How correlated are emerging markets sectors to developed markets sectors?

Kang: That’s a tricky question. It depends on your timeframe. In statistical terms, there’s just not a lot of data. But you can draw some general conclusions. There are times, like in the bull market from 2005-2007, when many sectors in emerging markets and developed markets were highly correlated. Commodity stocks were highly correlated during the commodities boon regardless of location. On the other hand during the credit crisis, financials haven’t been as highly correlated because banks in the U.K, for example, have been exposed to more toxic assets than banks in places like China, Brazil and India.

IU: What do you see as the biggest benefits of breaking emerging markets into sectors?

Kang: A lot of investors managing their emerging markets exposures are doing so by allocating between countries. The question we asked at the very beginning of creating our ETFs is how much overlap there is between sectors and geography.

Let’s say you’re an American investor with heavy exposure to the S&P 500 index. Maybe you’ve tilted your  portfolio a little to commodities through funds such as the SPDR Gold Shares (NYSE: GLD) and the iPath Dow Jones-AIG Commodity Index ETN (NYSE: DJP). If you’ve got that portfolio, you look more like a Canadian or an Aussie – both of those countries are heavily influenced by movements in natural resources prices.

IU: In other words, broader-based ETFs don’t add a lot in those situations?

Kang: The inclusion of broad emerging market ETFs as well as many of the country specific ETFs to this kind of portfolio would not provide diversification as correlations would be surprisingly high.  For true diversification, the inclusion of certain sectors would likely provide more optimal risk-return characteristics to the overall portfolio.

Furthermore, many investors who invest in emerging markets country ETFs do so based on a sector-type of rationale. For example, let’s say someone wants to invest in Russia. The question I would ask is: Do you want to invest in that country to be more richly compensated with some sort of political risk associated with that country? Or, are you investing in Russia to make an oil and gas bet? If that’s the case, do you want to put all your eggs in one basket – Russia. Or, would you prefer to invest in a basket focused on oil and gas but with companies from Russia, India, China, Brazil and several others?

IU: Those are the top countries in EEO, aren’t they?

Kang: Yes. Those four countries comprise roughly two-thirds of the fund. And with EMT, the top countries are: South Africa, Brazil, China and Russia. Those take up more than three-quarters of the fund.

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