Emerging Opportunities

Emerging markets are a hot topic in investment circles, and it’s easy to understand why: some have yielded returns of close to 50% in the past year. Such returns reflect much higher levels of risk, so how can investors take advantage of these returns without taking an unnecessary gamble?

One way to reduce your liability is to invest via emerging market funds, which limit exposure to any one market by spreading capital across several regions, countries and industries.

With returns on the ASX forecast to slow down over the next two years, emerging markets have become an increasingly attractive option. Typically, they hold the promise of securing returns that are better than those offered by developed markets. Stockmarkets within developing nations trade a discount of about 6% and offer favourable price/earnings ratios of 10.4 '” that mean stocks are relatively cheap and returns on equity in global emerging markets are as high as 16.7%, according to Mercer Investment Consulting. The ability to implement proven management techniques in new regions, and the competitive manufacturing costs available in less-developed markets, open the possibility of making substantial gains.

The emerging markets sector is a big business with fantastic stories. The doyen of emerging markets, Dr Mark Mobius, the managing director of Templeton Asset Management, traverses the globe in a private jet overseeing a $US20 billion portfolio. In Australia, the sector is still in its infancy and limited to a small number of funds, many of which are available only through wraps that hit investors with large fees.

One of the best-performing emerging market funds offered to Australian-based investors is that of global investment group Lazard Asset Management, which has been offered locally since 1997. Over the past year the fund returned a profit of 47.4% and is listed by independent research group Morningstar as the top-performing retail fund in Australia.

Portfolio manager James Donald says: “The success of the fund is entirely dependent on stock selection. Our materials, industrial and financial holdings have all contributed to the success of the fund. In addition our interests in energy stocks, particularly PetroKazakhstan, have played an important role in our third-quarter results.”

Lazard’s financial holdings include the State Bank of India, Turkey’s Akbank and Korea’s Kookmin Bank. PetroKazakhstan is an exporter of oil and gas products, based in the Republic of Kazakhstan.

“Telecommunications have also performed exceedingly well,” Donald says. “We have interests in a number of regions such as Russia and the Middle East where there is limited 3G risk, huge growth in subscriber numbers and a competitive structure that complements our investments.”

But can Lazard and Donald continue to achieve these results? It is believed that most emerging market funds reach a critical mass at $US5–10 billion. The global Lazard emerging market fund controls $US2.5 billion of capital, which will allow it to continue to grow significantly '” for the time being at least.

Though the emerging markets funds sector is enjoying a new wave of interest, the majority of the world's best known funds are not sold locally. For investors willing to go beyond the offices of locally based fund mangers the range improves dramatically. (For a list of top emerging market funds open to all investors -including Australians - see the attached resource - Leading Overseas funds).

For investors who prefer to deal with locally sold funds the list is relatively restricted. Apart from Lazard's high flying emerging markets funds other options open to Australian-based investors include ABN-Amro, ING, Macquarie Bank and Zurich that have all offered investment trusts for retail investors at different times.

ABN-Amro’s retail product, the Emerging Markets Equity Fund, requires a minimum investment of $20,000 and is managed a team based in Amsterdam. Typical of many emerging market funds, almost half of its focus is on Asia, with investments in such companies as Samsung Electronics and Kookmin Bank. Both are based in Korea, making them well placed to take advantage of capital growth in the region.

Samsung and Kookmin are also included in the portfolios of Lazard and ING. In addition, the Russian Lukoil Oil Company and the Brazilian mining company Companhia Vale Do Rio Doce also make up a significant portion of the portfolios of all three emerging market funds mentioned in this article.

Fund Name	APIR Code	Minimum Amount	Available through	Entry Price $	Exit Price $	Total Return 1 yr %	Total Return 3 yr %pa	Total Return 5 yr %pa	Net Assets $mil	MER %pa	Manager Name
ABN AMRO - Emerging Markets Equity Fund	ARO0010AU	$20,000	ABN AMRO	0.99	0.97	37.20	19.50	7.20	1.30	1.96	ABN AMRO Asset Management (Australia) Limited
ING OA Inv Pfolio-ING Glbl Em Mkt Sh NEF	MMF0270AU	$10,000	ING's OneAnswer Wrap	1.07	1.06	32.80	12.82	N/A	1.75	2.45	ING Funds Management Limited
ING OA Inv Pfolio-ING Glbl Emrg Mkts Sh	MMF0265AU	$1,000	ING's OneAnswer Wrap	1.07	1.06	33.50	13.01	N/A	1.66	1.90	ING Funds Management Limited
Lazard Emerg Markets Fund	LAZ0003AU	$1,000	BT Wrap, Macquarie Wrap, Portfoliocare	1.51	1.48	47.4	26.9	10.1	48.2	1.05	Lazard Asset Management
Entry and exit price figures from Morningstar are accurate as of 18 November 2005.

The Asian focus is not without risks of its own. Some analysts believe one event that could have catastrophic repercussions would be an Asian bird flu pandemic, which would likely trigger huge capital outflows to developed markets. Others believe the repercussions would be far wider, going far beyond Asia.

An assumption that underlies investment in emerging markets is that fast-growing economies provide the ideal environment for companies to realise profits. The real GDP of emerging markets is about 3.5% compared with 2.6% in developed markets. It is also true that shareholders are now better protected than they were during the Asian financial crisis of the late 1990s. But it would be naïve to assume a direct relationship between a booming economy and stockmarket gains. No one would deny China’s status as an economic fairytale, but since 2001 its stockmarket could only be described as a nightmare.

The above chart from Morgan Stanley Capital Investment, reproduced by Mercer Investment Consulting, illustrates the premium returns emerging markets can produce. Over a 17-year period to March 2004, the Emerging Market Free index outperformed that of the developed world by more than 4% a year.

Mercer Investment Consulting believes that although Australia has a reasonably high level of integration with Asia, it is insufficient to take advantage of the unique levels of risk and return that are presented by emerging markets (see attachment).

ING Investment Management offers an emerging market fund, the Global Emerging Market Fund or the GEM. It is available thorough ING’s OneAnswer investment platform, which contains 67 other fund types.

Luke Benjamin, the head of marketing at ING Australia, says: “GEM in particular would typically represent 5–10% of the international equity in a client’s portfolio. However '¦ the allocation is directly related and dependent upon the client’s risk profile and investment objectives.”

Such comments highlight the very real risks involved in emerging markets. Although the returns produced by the GEM fund over the past 12 months were about 33%, they were a much more subdued 13% a year when averaged over a three-year period.

Zurich Financial Services offers several funds for allocated pensions, but is in the process of closing its only retail emerging market fund. Macquarie Bank’s Emerging Market Share Trust is no longer accepting new investors.

The available research is certainly enticing. Goldman Sachs says that within 40 years the combined economies of Brazil, Russia, India and China may become larger than the G7 group of nations in US dollar terms. Additionally, China may be larger than the US by 2041 and India larger than Japan by 2032.

Conversely, factors that threaten the ongoing profitability of emerging market funds are very real and very tangible. An abrupt rise in US interest rates, for example, would be catastrophic. Emerging markets are characterised by their low levels of dedicated capital and this would prove a serious impediment to their ongoing growth. Political disturbances are a feature of developing countries and cannot be ignored.

Like any investment, emerging market funds are best suited to investors looking to realise profits over the long term. Unlike other investments they represent considerable risk to the investor. Investors looking to take advantage of emerging markets would do well to study how such funds allocate capital and could altogether avoid the charges associated with them.

Oil poor nations, a possible bird flu crisis and an overdependence on China all represent high risks to emerging markets. While the strategy of spreading funds throughout different regions and industries is a sound one, it is equally important that the mix is weighted correctly. Many emerging market funds will already be reaping profits based on discounts applied to the regions affected.

Overall the best strategy is one that includes these markets as part of a much broader portfolio. In the same way, investors that choose to purchase specific stocks from emerging markets would do well to evaluate just how much exposure they are prepared to take on.