Manila is hot, but is its ETF worth an overweight?

A look at the top-performing emerging markets of the year so far reveals plenty of familiar names to Emerging Money readers, but one country — the Philippines — that doesn’t get much coverage.

Image courtesy Randy Lemoine:

The city of Makati, one of the cities and municipalities that make up Metro Manila. It is the Philippines' major financial, commercial and economic hub

The MSCI Philippines index is up 23.35% in 2012, putting Manila ahead of everyone but Thailand (THD, quote), Colombia (GXG, quote), Indonesia (IDX, quote), Hungary, and a few outlying frontier economies, not to mention the resurgent Egyptian (EGPT, quote) market.

Over the last 12 months, this is actually the best market in the world, up 30%, while the broad emerging markets funds like EEM (quote) are down over 13%.

While those 43 percentage points in raw outperformance do look incredibly appealing, most seasoned emerging markets traders know that today’s winners can all too easily turn into tomorrow’s losers, and vice versa.

Egypt for example, is bouncing off a spectacularly bad 2011, in which its stocks plunged a full 48%. And Hungary is only now recovering from two disastrous years that destroyed 42% of the value of its local market — but back in 2009, the Budapest rollercoaster gave traders a 73% return.

Naturally, traders want to overweight the areas of the global economy they suspect will outperform, while limiting their exposure to next year’s losers. The Philippines, for example, has a lot going for it: estimates of 3.6% to 4.2% top-line growth this year, a fast-growing consumer sector, the biggest English-language outsourcing industry in the world, and massive inflows of funds from expatriated workers sending their wages home.

While the dedicated Philippine ETF EPHE (quote) gets a lot of praise in the investment press, it’s often in vague terms that really boil down to not wanting to question success. On those terms, the fact that EPHE has given traders a net 20% since the fund launched in September 2010 — a period in which EEM lost 4% — is self-evident as history, but does little to inspire confidence in the future.

In a market-neutral global portfolio, EPHE should only account for 0.3% of a GDP-weighted strategy. That’s not much, but it does reflect the real scope of the Philippines’ $200 billion economy within the $63 trillion global system.

Taking a market-capitalization-weighted approach, the result is the same: every share of every stock trading in Manila is worth $165 billion, the global equity universe is worth $45 trillion, a market-weight allocation to EPHE should come closer to 0.4% of the portfolio.

Doing this math is doubly useful because it shows us whether a market is over- or undervalued in terms of underlying economic footprint. In the case of the Philippines, we seem to be a little rich, but that’s to be expected in any rapidly industrializing country where traders pay a premium for growth.

So is EPHE worth more than a measly 0.4% of your portfolio?

To answer the question, we need to drill down into the fund’s holdings to get a better sense of whether they’re collectively outperforming the global economy.

The Philippines is not extremely export-oriented, with only 24% of the economy representing goods and services shipped abroad. Most of the major players in this space are foreign companies taking advantage of the country’s relatively cheap cost environment.

As such, EPHE is heavily weighted toward services, as is the underlying Philippine economy. However, it’s tricky to get a sense of which portfolio company fits into a given sector.

All the major banks and telecom carriers are represented, including Philippine Long Distance Telecom (PHI, quote), the only Philippine stock that reliably trades in the United States. And most of the companies that account for the 15% of pure consumer allocation in EPHE are fairly easy to figure out — they’re growing along with the domestic middle class.

However, the portfolio also includes the country’s leading family-operated diversified conglomerates, which provide exposure to every aspect of the Philippine economy from farming to its burgeoning chains of shopping malls.

Given the concentrated and somewhat clubby nature of Philippine business and politics, it’s likely that these family empires will continue to expand at least as fast as national GDP, and will if anything, drive it in key ways.

With that in mind, EPHE seems to be the best of both worlds: growing fast at home and relatively insulated from the risk factors overseas trading partners may currently be facing. And momentum is definitely on its side — so maybe it’s worth a little more than 0.3% of your attention?