Last year, the sharp pullback in emerging market stock indexes and the ETFs that follow them made the downturn in the U.S. market look tame by comparison. This year, a roaring comeback for the group has left many wondering if the rally signals a long-term shift in investor perception of those markets, or the prelude to an equally punishing rout.

In either case, the outsize gains have sent assets flowing into emerging market ETFs at a torrid pace. The iShares MSCI Emerging Market Index Fund (EEM), the largest emerging market ETF, was up 74% for the year ending October 20. At $37 billion in assets, it is now the third-largest ETF on the market. By comparison, the iShares MSCI EAFE Index Fund (EFA), which follows developed international markets, was up 31.85% over the same period, and the SPDR S&P 500 Index Fund (SPY), was up 19.83%. Some single-country ETFs, including those following Brazil and Russia, have posted even more robust gains.

Given the sharp rally, it is no surprise that emerging market red flags are popping up as concerns mount over unsustainable values and the potential for a pullback. An early salvo came in August from Morgan Stanley analyst Andy Xie, who labeled the Chinese market, a major component of many emerging market ETFs, "a giant Ponzi scheme." Xie cited inflated equity and property values driven by the expectation of appreciation as the underpinnings of a bubble.

"When the dollar revives, China's asset markets, and probably the economy, would have a hard landing," he warned. Another warning comes from Elroy Dimson, a professor at London Business School, who notes in a study that stocks from countries with the highest economic growth produced lower returns than those of slower-growing nations over the long term, largely because of the inflated valuations of the former group.

Higher valuations also pose additional risk. At the beginning of this year, emerging market stocks traded at single-digit price-to-earnings ratios after losing over half their value in 2008, and thus looked like a bargain compared with U.S. stocks. By late summer that discount had narrowed significantly as U.S. stocks began catching up and emerging markets climbed at a more subdued pace. Price-earnings ratios and other valuation metrics in some markets, such as China and India, now exceed those in the U.S. Lingering memories of Russia's 1998 default on its Treasury bills, the Asian currency crisis of 1997, and other emerging market collapses of the not-so-distant past add to valuation concerns.

But to get the full picture, investors should look forward as well as backward says Alec Young, equity market strategist at Standard & Poor's. The MSCI Emerging Markets Index typically fluctuates between 10 and 17 times earnings, he says, and right now it is near the top of that range based on estimated 2009 earnings. However, based on expected earnings in 2010, the index is trading closer to 13 times earnings. "There is going to be room for gradual PE expansion over the next 12 months," he says. "Gains are going to be more modest going forward, but they will still be quite strong."

Young says the rapid rise in emerging market stocks reflects the belief by investors that those markets will experience stronger GDP and profit growth than their developed market counterparts. In 2010, Standard & Poor's anticipates GDP growth of 2.9% for Latin America, 0.6% for euro zone countries, 10% for China, 7% for India and 1.6% for the U.S.

Others concur with Young's view. In a report titled "Emerging Markets in the New Normal," PIMCO managing director Curtis Mewbourne says that while the U.S., Europe and Japan are still the largest and most dominant economies, "these economies are reaching the tipping point of global economic impact." He points out that in terms of GDP, emerging market economies account for seven of the top 20 countries. The BRIC countries, in particular, share the competitive advantage of low labor costs, low levels of consumer debt and large populations to drive domestic demand.

For some, last year's worldwide rout showed that the global nature of today's marketplace leaves few shelters in a recession, making the perception of safety of developed countries grounded more in wishful thinking than reality. Gary Gordon, the president of Pacific Park Financial in Aliso Viejo, Calif., acknowledges that emerging market stocks and ETFs that cover them appear overbought and are due for a pullback. But he questions the notion of greater safety in developed markets.

"How about the safety of the countries where the companies have the most potential to grow?" he asks. "And isn't there safety in economic expansion, foreign investment elsewhere and demographic trends? And what about the safety of ten-year rolling returns? Emerging markets have rewarded investors over the last ten years while U.S. and European investors have lost money." He adds that moving emerging market exposure up a notch-say, from 3% of portfolio assets to 8%-has no impact on portfolio risk but contributes to higher returns.

Still, this year's run-up in emerging markets has Gordon concerned about a downturn in the notoriously volatile group, and he recently sold a position in the iShares Brazil Fund (EWZ) for that reason. If there is a pullback, he plans to pick up a small company ETF that focuses on domestic consumption in emerging markets such as Brazil or China.

Narrowing The Focus
A couple of years ago, such narrowly focused emerging market ETFs were rare. Now, single-country, market-cap specific and sector plays make up the bulk of new emerging market offerings. The most popular single-country ETFs cover each of the BRICs, but some venture into more far-flung regions of the globe such as Africa or Turkey. And a growing roster of "frontier" ETFs explores areas such as Egypt, Vietnam, Kazakhstan and Chile.

Liquidity varies among the group. The most popular single-country ETF, iShares Brazil, has over $10 billion in assets and trades over 16 million shares a day. The Van Eck Market Vectors Russia ETF (RSX) has average daily trading volume of over two million shares and assets of $961 million, while the firm's Brazil small-cap offering (BRF) has average daily trading volume of about 400,000 shares and assets of $289 million. But with so many emerging-market newcomers, low trading volume can be a concern and some, such as iShares MSCI Israel (EIS) or Emerging Global Advisors Metals & Mining (EMT), trade less than 100,000 shares on a given day.

Because a country's economy often hinges on one or two sectors, emerging market returns can vary enormously. For most of this year, concerns about the credit crunch's impact on growth in consumer spending suppressed returns in Eastern Europe. On the other hand, rising commodity and materials prices and infrastructure expansion have turbo charged the Brazilian and Russian markets.

Carl Delfeld, publisher of Chartwelletfadvisor.com, uses single-country ETFs to complement broader emerging market ETF holdings. "The problem with diversified emerging market ETFs is that they tend to have most of their assets in a few countries, so this is one way to broaden exposure, or to overweight exposure to specific areas," he says. To protect longer-term holdings he monitors positions frequently and sets trailing stop orders. "Sizable gains and pullbacks are much more frequent in emerging markets than developed ones, especially among the single-country funds. You can't be asleep at the wheel," he cautions. Delfeld also uses ProShares Short MSCI Emerging Markets Fund (EUM), an ETF that moves in the opposite direction of the MSCI Emerging Market Index, when he feels the sector may be ripe for a downturn.

Despite the growing popularity of single-country and sector ETFs, two diversified offerings continue to dominate the emerging market ETF landscape. Both the iShares MSCI Emerging Markets Index and the Vanguard Emerging Markets Index (VWO) share the MSCI Emerging Markets Index as a bogey, but they differ in how their portfolios are structured. The latter ETF holds all the stocks in the index, while the iShares offering uses a sampling subset for replication. Although country and sector weightings are similar, the differences in index composition and structure have added up to produce disparate returns this year. Through the third quarter, VWO was up 75.35% year to date, while the EEM had risen 67.6%, according to Morningstar data.

Smaller diversified emerging market ETFs offer alternatives to the MSCI Index. The PowerShares FTSE RAFI Emerging Markets Portfolio (PXH) tracks a proprietary, fundamentals-based index and has its largest weighting in South Korea. SPDR S&P Emerging Markets (GMM) uses an index that omits South Korea and has a competitive expense ratio of 0.59%. But with average daily trading volume of 81,000 shares and 15,000 shares, respectively, they have yet to develop a sizable fan base.

Emerging market ETFs currently in registration, most of them focusing on concentrated niches within the emerging market universe, provide a glimpse of what to expect in 2010. They include an India Nifty Fifty fund from Barclays; 3X Bull and Bear Shares for China, the BRICs and Latin America from Direxion; a family of emerging market sector funds from Emerging Global Shares; and several dividend-focused emerging market ETFs from WisdomTree.

Carl Delfeld, publisher of Chartwelletfadvisor.com, uses single-country ETFs to complement broader emerging market ETF holdings. "The problem with diversified emerging market ETFs is that they tend to have most of their assets in a few countries, so this is one way to broaden exposure, or to overweight exposure to specific areas," he says. To protect longer-term holdings he monitors positions frequently and sets trailing stop orders. "Sizable gains and pullbacks are much more frequent in emerging markets than developed ones, especially among the single-country funds. You can't be asleep at the wheel," he cautions. Delfeld also uses ProShares Short MSCI Emerging Markets Fund (EUM), an ETF that moves in the opposite direction of the MSCI Emerging Market Index, when he feels the sector may be ripe for a downturn.

Despite the growing popularity of single-country and sector ETFs, two diversified offerings continue to dominate the emerging market ETF landscape. Both the iShares MSCI Emerging Markets Index and the Vanguard Emerging Markets Index (VWO) share the MSCI Emerging Markets Index as a bogey, but they differ in how their portfolios are structured. The latter ETF holds all the stocks in the index, while the iShares offering uses a sampling subset for replication. Although country and sector weightings are similar, the differences in index composition and structure have added up to produce disparate returns this year. Through the third quarter, VWO was up 75.35% year to date, while the EEM had risen 67.6%, according to Morningstar data.

Smaller diversified emerging market ETFs offer alternatives to the MSCI Index. The PowerShares FTSE RAFI Emerging Markets Portfolio (PXH) tracks a proprietary, fundamentals-based index and has its largest weighting in South Korea. SPDR S&P Emerging Markets (GMM) uses an index that omits South Korea and has a competitive expense ratio of 0.59%. But with average daily trading volume of 81,000 shares and 15,000 shares, respectively, they have yet to develop a sizable fan base.

Emerging market ETFs currently in registration, most of them focusing on concentrated niches within the emerging market universe, provide a glimpse of what to expect in 2010. They include an India Nifty Fifty fund from Barclays; 3X Bull and Bear Shares for China, the BRICs and Latin America from Direxion; a family of emerging market sector funds from Emerging Global Shares; and several dividend-focused emerging market ETFs from WisdomTree.