Why you should fall in love with emerging markets

UK investors are in the throes of a passionate love affair with emerging markets. The volume of sales has doubled over the past year, with net sales amounting to over £686 million in 2009 compared with £321 million the previous year.

Not so long ago, most of these investors would have had little to do with emerging markets on the grounds that they were just too temperamental.

And, of course, there will still be stormy times ahead – even the most rewarding relationships will always have their rocky moments. But those who have lost their hearts to the emerging economies believe that this time it could really last.

Getting intimate

So what exactly are the emerging markets? The biggest emerging economy powerhouses are the BRIC nations (Brazil, Russia, India and China), but a wide range of smaller players also feature, including Turkey, Morocco, Israel, eastern European countries such as Poland, Hungary and Romania, other Latin American states such as Chile, Colombia and Mexico, and Asian nations such as the Philippines, Malaysia and Indonesia.

It's not hard to see why investors have been swept off their feet by these unpredictable beauties. Although stockmarkets globally were hard hit by the financial crisis, the recovery of emerging markets in particular has been truly spectacular, as fund returns show.

For example, Allianz RCM BRIC Stars is up 95% over 12 months to 8 December 2009; the three India funds available (from Jupiter, First State and Neptune) have all returned between 82% and 93%; while the Latin American specialist funds are up more than 100%.

Even more general global emerging markets investments have produced pretty heart-stopping results: the IMA Global Emerging Markets sector is up an average 72% over the year.

By contrast, the UK, despite a perfectly respectable 35% average return from the IMA UK All Companies sector, looks a little dowdy.

You don't have to look far for evidence of the way many UK investors feel. Take, for example, Moneywise's sister-website, Interactive Investor, where six out of the eight best-selling funds in 2009 were either single-country specialists or global emerging markets investments.

Independent financial advisers are making similarly impassioned noises.

"Emerging markets represent the most compelling long-term investment opportunity; investing in emerging markets represents an investment in the shifting new world order," says Ben Yearsley, investment manager of broker Hargreaves Lansdown.

"Emerging markets are no longer an investor's exotic afterthought. Such has been their remarkable success in recent times that they have become a significant portion of many portfolios," adds Darius McDermott, managing director of Chelsea Financial Services.

Yet there's nothing new in high returns from emerging markets. The global emerging market sector has grown on average by almost 30% a year over the past five years, and the Latin American specialist funds by over 50% a year.

Love at first sight?

What has provoked this change of heart among investors? Mike Horseman, managing director of IFA Cockburn Lucas, explains: "Two years ago I was more concerned about the volatility and high risk of these regions, and I wasn't looking deeply enough at the fundamental drivers that make them such a powerful long-term investment prospect."

One key driver is the fact that the world's natural resources are concentrated among the emerging economies. Global demand for commodities, although volatile, can only rise over the long term as populations grow.

Another is the issue of demographics – these countries have youthful, energetic, growing populations, whose spending habits are dramatically changing as they become wealthier and more urbanised.

"Car sales in the top 16 emerging countries are now much stronger than in the US, Japan and developed Europe combined," explains Allan Conway, head of the Schroder emerging markets team.

"Domestic demand has become an increasingly important driver of growth in the emerging world as disposable income increases."

Conway observes that the shift in focus from exports to domestic demand means emerging economies will continue to outperform their developed peers.

"In the past, emerging markets would have suffered far more from a global recession as they were largely dependent on their exports. However, over the last 10 years, emerging economies have strengthened and are now growing 3% to 5% faster than the developed economies every year."

He suggests that even with a recovery in the developed world, emerging economies will account for 70% to 75% of global growth every year "for the foreseeable future".

At Aberdeen Asset Management, head of equities Hugh Young points out that the whole development of emerging economies is entering a new phase as they start to produce their own home-grown world-class companies, rather than Western subsidiaries or support services for Western industries.

"The likes of Samsung Electronics, TSMC, Hyundai Heavy Industries and Yue Yuen are now the global leaders in their industries, while many more are world-class enterprises," he says. That gives stockpicking fund managers a growing arena from which to choose.

Apart from the underlying potential for economic growth, the stockmarkets of these countries have matured to some extent: there are more shares available and more domestic investors involved.

Additionally, Horseman says: "There's evidence that more and more big long-term investors – pension funds, trusts, charities – are ramping up their emerging market allocation."

That means more long-term money in the markets, and therefore less chance of a complete meltdown when the markets suffer a setback – as they're bound to do.

Will the love affair last?

While in the long term the emerging market growth story looks compelling, there are likely to be hiccups in the shorter term.

Conway thinks emerging markets will see a correction of 10% to 15%, probably on the back of fears of a 'double dip' downturn for Western economies. 

Horseman agrees that emerging economies may now be "too hot", having rallied by around 100% since the low point in March.

"Should investors wait for markets to cool down before they buy? Trying to call the markets is a dangerous game, and if you're investing for the long term it's not worth it," he says.

"But it might well be sensible to phase in your investments through a regular savings scheme over the coming months, so that you're not caught full on by any correction."

So who should invest in emerging markets? As we've seen, advisers increasingly consider them to be a core part of any portfolio.

"They're no longer just a speculative punt but a strategic long-term holding, and investors will need to be there to get the kind of long-term returns they need," says Horseman.

How much exposure is sensible?  Mark Dampier, head of research at Hargreaves Lansdown, advises younger investors to hold between 20% and 50% of their pensions in emerging markets, but stresses it's not a good idea if you're approaching retirement, as your funds might not have time to recover from a crash.

So, overall, the message is that investors cannot afford not to be in these exciting markets if they want decent growth – but it needs to be a long-term commitment.

Case study – China

China has sidestepped the worst of the global downturn, in large part because its government took dramatic action in November 2008, injecting almost $600 billion into the economy (mainly through big infrastructure projects).

As a result, although exports have been hard hit recently by a fall-off in the sale of manufactured goods to cash-strapped consumers in the US and other developed countries, the forecast is still for economic growth of 9% to 10% for 2010 and 2011.

The latest outlook is that China will knock the US off the pedestal and become the world's largest economy by 2030, or possibly earlier.

Industrialisation and new opportunities in the cities means 15 to 20 million people a year are moving to urban areas from the country; 45% of the population now lives in the city.

Better jobs are bringing increased prosperity (average wages rose 13% year on year in the first half of 2009).

And that means growing numbers of consumers are spending more on luxury goods (such as cameras, mobile phones and digital TVs), imported foods and cars. Retail sales growth in China is much stronger than in the US.

Allan Conway, head of the Schroder emerging markets team, says: "This is the first time in history that an economy has emerged to become a major world player with domestic demand as the primary driver; in the UK, US and Japan, for example, this kind of development has been export-driven."

And Chinese domestic demand is also helping other emerging countries. "China's robust domestic economy – in terms of both hard asset investment and domestic consumption – has provided a new end-market for commodities and consumables from countries such as Brazil, Indonesia and Russia.

There has been a dramatic increase this year in exports to China from trade-oriented countries such as Taiwan and Korea, which have been switching sales of electronic products such as flat-screen televisions towards China," says Ewan Thompson, fund manager at Neptune Investment Management.

Emerging markets fund recommendations

Raj Shah, director of the Blue Partnership recommends, Neptune Russia and Greater Russia:

"Manager Robin Geffen has been investing in Russia for over 15 years and knows what he's doing. The fund has almost doubled over the year to 8 December 2009, relative to the IMA Specialist sector average of 37%.

China is proving to be a major consumer of Russia's enormous natural resources, so China's growth is very positive for Russia."

Steve Laird, senior partner of Carrington Wealth Management, recommends First State Global Emerging Markets:
"Emerging markets are much less efficient than developed markets so you need a good manager to pick the right stock.

Angus Tulloch of First State Global Emerging Markets is that man, able to deliver high returns for relatively low risk." The fund has gained 62% in the past 12 months, and 170% in five years.

Gordon Bowden, director of Quainton Hills Financial Planning, recommends First State Indian Subcontinent:

"First State has a very good reputation for its emerging market funds, but for those happy to ride the volatility rollercoaster, India in particular is the place to be.

First State Indian Subcontinent (up 86% over the 12 months to 8 December 2009) is not one for your grandmother, but as India becomes an increasingly dominant economy, the rewards could be huge."

Peter McGahan, managing director of WorldWide Financial Planning, recommends Aberdeen Emerging Markets:

"This is an excellent fund for someone wanting exposure to emerging markets but with the risk reduced by outstanding research."

It's up 73% over the past 12 months, but also offers impressive consistency, ranking first in the global emerging markets sector over three years and second over five years.

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