Beef up your emerging market exposure

Wealth management firms are recommending that clients increase their portfolio exposure to emerging markets, often to 15% or more compared with around 5% two years ago.

The thinking is that this better reflects the emerging markets' burgeoning share of the global economy and will avoid portfolios incurring a systematic bias to the developed world.

Emerging markets already account for 35% of global GDP (50% at purchasing power parity), while the UK represents no more than 10%.

The second strand to this argument is that investing in emerging markets today is like investing in the Industrial Revolution 200 years ago. While developed markets offer the prospect of 2% to 3% annual growth, emerging economies are on growth trends of around 7% to 8%, increasingly fuelled by domestic consumption.
"There are growth stories all over the emerging market countries," says Dr Mark Mobius, veteran manager of Templeton Emerging Markets Investment Trust.

"If we look at the macroeconomic picture, the major growth countries are China and India, but there is high growth in a number of smaller markets, and particularly in frontier markets.

"We prefer the commodity and consumer sectors. Demand for commodities is soaring and the cost of discovering and producing commodities is escalating.

In the consumer area, per capita incomes in emerging markets are rising fast. That, combined with the large populations in India and China, means the demand for consumer products and services is growing rapidly."
In contrast, more mature European markets with ageing populations have little capacity to grow their spending. "The movement of factories to eastern Europe means less in the way of job opportunities for people in developed nations," warns Nick Price, portfolio manager at Fidelity.

"With the exception of hearing aids, it's a battle to find any product in sustained growth. Meanwhile, the Asian consumer is enjoying increased consumption of almost everything from clothing to autos."

The commercial potential of these populations developing western tastes is huge. For example, the annual volume of beer sales in Nigeria is growing by 10%. And the level of credit extension in poorer societies is low - even items such as motorbikes are purchased in cash.

In Vietnam, for example, only 10% of consumers have a bank account. The urbanisation of highly skilled workers is creating a dynamic and innovative commercial environment.

"Economic growth is compelling not only in China and India, but in Indonesia, Turkey, Brazil and Russia, which are well positioned for several years owing to current account surpluses and huge foreign exchange reserves," says Wim-Hein Pals, manager of the Robeco Emerging Markets fund. China famously has $2 trillion (£1.25 trillion) in foreign exchange reserves.
The transformation in fiscal and monetary status is marked, and is starting to make the evils that have dogged Asian markets - currency crises and the flight of capital - recede. But emerging markets remain volatile, as demonstrated by China's Shanghai Composite index, which fell back by 21% in August after doubling since November.
Mobius stresses that investors should take a five-year investment view and be prepared for extreme volatility. "There are always corrections, even in a bull market, and they can be violent, big and hard to catch."

One fear is that stock valuations are unreasonably high in relation to earnings per share and that Chinese output growth will ease back, while in Korea and India, there is also a renewed focus on falling export levels.

"Emerging markets have already bounced higher than the rest of the world, but my view is that this idea of emerging markets decoupling from the West has not yet materialised.

Last year when developed markets fell, they all fell, and I do think another downturn in developed markets would pervade emerging economies,' says John Dickson, head of investment consultancy at Hymans Robertson.

"Valuations are now at long-term historic averages, but we still feel stocks offer excellent long-term growth and will see good sustainable profits," argues Emily Whiting, a lead portfolio manager on the JPMorgan Emerging Markets Investment Trust.

"A particular inefficiency is that banks have been grouped and sold down together, particularly Chinese financial names that we like but previously considered too expensive."

Immediate exposure

Access to these markets has become easier over the past decade. Exchange traded funds (ETFs) offer immediate exposure with prices quoted in real-time on mainstream markets.

The broad MSCI index-tracking ETFs, such as those developed by iShares and db x-trackers, or the similar Vanguard Emerging Markets fund, are huge, collectively holding more than £3.8 billion in assets.

A wide range of style biases  and single-country ETFs, such as iShares' China, Brazil and Turkey funds, are also available.
Low annual charges, at around 0.36%, make ETFs only half as expensive as traditional passive equity funds, and just a fraction of the cost of actively managed equity funds.

There are compelling arguments favouring passive strategies where a market is enjoying astonishing secular growth, particularly where researching companies is not always easy.
But there is also an argument that in inefficient markets, where sense must also be made of 25 to 30 countries that are at different stages of development, a skilled active manager should be able to outperform the broad emerging markets indices, and that is borne out by the performance of unconstrained funds such as the Capital International fund.

The relaxation of the Ucits fund regime to allow greater use of derivatives, while maintaining all the advantages of daily liquidity and the inherent risk control structures, has been welcomed by some investment managers, such as the well regarded M&G Global Emerging Markets fund.

Some Ucits funds almost resemble hedge funds or structured products - such as Parworld Emerging STEP 80 fund - that buy options on trackers to ramp up the impact of market moves.

Many specialist investment trusts, particularly trusts with a bias to defensive strategies, have underperformed the market in recent months and are trading at heavy discounts to their underlying asset values, opening up the possibility of a double gain as their discounts to net asset value tighten.

VinaCapital's Vietnam Opportunity trust has performed well, making nearly 80% in the six months to September, yet is still on a discount of 33%.

"As trusts often trade on a discount, this plays out better in a rising market,' says Whiting. "Another key benefit of investment trusts is that they are closed-ended vehicles and do not need the daily liquidity required by Oeics and Sicavs, and this allows portfolios to drill down to lower liquidity stocks of the type that will grow 5, 10 or 20 fold."

The JPMorgan Emerging Markets Trust is around 10% to 15% invested in companies with market capitalisations of under $2 billion - significantly more than the small-cap weightings in corresponding Ucits portfolios.
Emerging markets' characteristic large trade surpluses, small government debts, large export sectors, high savings rates and readiness to allow their currencies to appreciate also add up to good conditions for bond buyers.

Some nations, such as Brazil and Russia, are now said to offer lower default risk than certain western countries. Brazilian government bonds currently yield 8.75% and settle in dollars, so provide an additional currency boost.

There aren't many emerging market debt funds available. Ashmore Investment Management runs offshore emerging market debt funds that are open to retail investors and Skandia has added the Goldman Sachs AM Emerging Market Debt fund to its Spectrum MultiManager range.

There are also bond ETFs such as the JPMorgan US$ Emerging Markets Bond Fund, traded on Arca, the NYSE electronic exchange.

Infrastructure is another way to access the industrialisation story. Jim Seymour, managing director of EMP Global, the private equity fund specialist, highlights the potential for power and logistics facilities such as warehousing and cold storage.

"I've been working in this industry since 1975 and this is indeed a tremendous opportunity for emerging markets. These markets are also at an advantage as they do not have a legacy of old decaying structures like the UK and Europe, and the demand and willpower is there," he says.

Another route to emerging market exposure is to buy individual shares with concentrated exposure to emerging markets such as City of London Investment Group and Ashmore Group, or US technology stocks such as Nasdaq-listed Qualcomm and New York-listed Micron Technology.

This article was originally published in Money Observer - Moneywise's sister publication - in November 2009

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