Despite the turmoil, should you consider emerging markets for your Isa?

12th March 2014

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Emerging markets have had a difficult time recently in terms of performance and suffering from concerns about tapering in the US. But could this actually mean it is a good time to invest if your horizon is long term. Investment journalist Cherry Reynard examines the issues.

Index providers categorise economies into developed markets – those such as the US or UK that have mature, industrialised economies and liquid capital markets – and emerging or developing markets, which are countries at an earlier stage in their economic development. An economy may be defined as ’emerging’ on the basis of low GDP per capita, or less well developed capital markets, or because it remains largely agrarian and pre-industrial. That said, the sector includes major global economies such as China, Brazil and India. Emerging markets are often growing faster than their developed market equivalents and companies based in these regions may offer investors the scope for considerable capital growth. The IMA sectors that cover emerging markets include Global Emerging Markets, China/Greater China, Asia ex Japan, plus funds listed in the Specialist sector, such as Latin America focused funds.

The range of fund strategies within sector

Emerging market funds are either general or specialist. In the generalist emerging market funds, managers will take a view on the best emerging markets around the world from a risk/return standpoint. Some managers invest purely from the bottom-up, looking for the best individual companies in emerging markets, rather than necessarily where companies are listed. Others will look ‘top-down’, picking the right country with strong GDP growth, and then finding companies that may benefit.

Fund managers will also have different ways of choosing companies for their portfolios. Some are focused on finding companies trading at low valuations, others on companies that have the potential for long term revenue growth. The most popular funds in the sector – those from Aberdeen and First State – have tended to focus on the large global companies within emerging markets, which have less risk, but also may not participate fully if markets move higher. The emerging market small cap sector is still relatively limited and under-developed with only a handful of dedicated funds.

Increasingly, there are a number of emerging market income funds available. These funds will pick companies within emerging markets that are paying a dividend. They believe that this tends to lead to companies with stronger corporate governance and better capital discipline. There are an increasing number of companies in emerging markets paying a dividend, as the management of emerging market companies moves to meet the needs of international shareholders.

Funds will also vary in the extent to which they follow an index. Some funds will aim to stick close to their benchmark index – usually the MSCI Emerging Markets. However, in emerging markets this tends to lead to a sector bias in financials, commodities and consumer companies. Others will be more ‘unconstrained’, and will be flexible enough to move away from benchmark weightings.

Country specific funds will follow a similar range of styles, but – as the name suggests – focus on one specific country or region.

There are designated China funds, for example, and a number specialising in Latin America.

What has the recent performance of emerging markets been like?

Over the past five years, the average fund in the Global Emerging Markets sector has grown by 67.7% and in the China/Greater China sector by 70.6%. This compares to average growth from the UK Equity Income sector of 101.5%, and from the Global sector of 74.4%. The sector has suffered recently from a combination of slowing growth in China, high starting valuations and weak investor appetite for risk. The tapering of quantitative easing in the US, and the resulting loss of ‘easy’ money in the financial system, has also hit emerging markets disproportionately hard.

By far the best performing funds over the past one, three and five years have been those with quality bias, such as those from Aberdeen and First State. However, these funds are now closed to new business so investors have to look a little harder. Specialist boutique groups such as Charlemagne and Somerset have proved popular with those unable to access the larger funds. Over the long term, emerging market smaller companies funds have done well, but they have been hit hard in the recent rout. The weakest funds have tended to be those with high exposure to areas such as Latin America, which have proved weak in recent years as Brazilian growth has slowed.

When does it perform well/badly?

In general, emerging markets perform better when investors want to take more risk: This is likely to be when economic growth is buoyant and investors have more confidence in the global economy. Money tends to slip away from emerging markets at times of greater risk aversion, even if those emerging markets are still experiencing strong economic growth, though many EM managers believe that increasingly the individual circumstances of different markets will have more of a bearing. For example recently those markets with smaller current account deficits generally did better in the sell off.

What sort of investor does it suit?

Emerging market funds tend to be a more adventurous pick for a portfolio, made after investors have built up core holdings in the UK and other global developed markets such as the US and Continental Europe. They would suit investors who are comfortable with the prospect of short-term capital losses, for the potential of long-term capital gains.

How much of a portfolio for low/mid/high risk investor?

Emerging markets currently form just over 10% of the MSCI World index. However, some asset allocators argue that they should form a greater part of investors’ portfolios, given the growth trajectory of a number of emerging markets.

Questions for investors to ask themselves before investing in EM

Is the fund manager based in the UK or on the ground in emerging markets?

How does the fund manager handle liquidity problems?

How does the fund manager manage currency exposure?

How does the fund manager conduct manager meetings?

How does the fund manager handle corporate governance issues?

Adviser comments and suggested funds

Rob Burdett, joint head of multi-manager at F&C Investments

“It looks very cheap now, in terms of P/E ratio, relative to developed markets, and relative to the history of emerging markets. Investors just have to lock it away and not look at it.”

Fund pick

Hermes Global Emerging Markets

JPM Emerging Markets

Gavin Haynes, investment director, Whitechurch Securities

“Emerging markets covers such a wide spectrum of different countries at different stages of development and investors should not tar them all with the same brush. We have already seen emerging markets underperform and currency weakness, so some bad news is priced into markets.”

Fund pick

JPM Emerging Market Income

Threadneedle Global Emerging Markets

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