Sweet spots in emerging markets

In the five years since the global financial crisis (GFC), advanced economies have struggled to pull themselves back from the brink, with some looking the worse for wear, and others just starting to show signs of sustained recovery.

But while all this has been going on in the West, emerging economies have toiled away at a furious pace in the ultimate game of catch-up.

When we talk of emerging markets, BRIC is the buzzword that most often comes to mind. But emerging markets have evolved significantly since the term was first coined in 2001, and the BRIC economies (Brazil, Russia, India and China) are increasingly viewed as yesterday’s news. As money pours into emerging markets, a broader exposure to a wider range of economies outside of the BRICs has become the preference among fund managers.

The new favourites competing for the title of “top emerging market buzzword” are the CAPPTs (Chile, Argentina, Peru, the Philippines, and Thailand), the TIMPs (Turkey, Indonesia, Mexico and the Philippines), and the CIVETS (Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa). The lure of these new players is that their stockmarkets offer better growth potential at cheaper prices than the well-known BRICs.

Benjamin Pedley, head of investments at UBS Wealth Management, says that for Australian investors, South-East Asia is a relatively easy market to invest in. The region has a lot going for it, with a number of countries on an upward cycle with the ratings agencies. Inflation is being contained as currencies strengthen and there is strong population growth as well as relatively low public debt.

All of this sets the stage for growth in the region, leading UBS to have a constructive outlook on the Philippines, Indonesia and Thailand. Each of these countries has performed strongly over the past year. In the 12 months to April 30, the MSCI Philippines Index delivered a net return of 43%, while the MSCI Indonesia Index delivered a return of 17%, and the MSCI Thailand Index 21.9%. This compares with the MSCI BRIC Index, which delivered a return of just 0.76%.

But that’s not to say the BRICs are completely out of favour. India is still on UBS’ radar and is currently the favoured BRIC, Pedley says, especially given the abating inflation pressures in the country.

For those looking to gain exposure to emerging markets, it’s important to be aware of the increased volatility present in stockmarkets in these economies. This is because the returns are largely driven by the flow of capital. When emerging markets are thriving, and money is flowing in, the stockmarkets outperform. But equally, when money flows out, it can cause quite sharp corrections. This is what we’ve seen this year, with emerging markets generally underperforming advanced economies.

The recent movement in the Australian dollar is another reason investors should consider increasing their holdings in overseas investments. Pedley says that, in general, investors who have a neutral view on their currency should have about 80% allocated in their domestic currency, and 20% in other currencies. Like any other form of diversification, this helps to lower the risk on a portfolio.

This is important for investors to keep this in mind as we see the Australian dollar slip from its lofty highs right before our eyes. As the tide continues to turn against the dollar, a growing number of analysts and brokers are lowering their forecasts closer to the US90c – US80c mark by the end of the year. For the savvy investor, there could be some gains to be had.

For Australian investors keen to take the plunge, managed funds are no longer the only answer. In recent years, exchange-traded funds have become increasingly popular among retail investors. In Australia, the most well-known emerging market ETF provider is iShares. It offers a number of options for small investors, from broad-based exposure in the iShares MSCI Emerging Markets (IEM) to ETFs that focus on specific countries like Taiwan, China, and South Korea.

Source: iShares

For those who would rather shy away from ETFs, managed funds are a well-established option. Morningstar’s latest research on managed funds ranked Colonial First State Global Emerging Markets Select Fund as number one, with a gold rating, while Aberdeen Emerging Opportunities Fund and Lazard Emerging Markets Fund were the next-highest ranked, with silver ratings. Both Colonial First State and Aberdeen recorded some of the highest returns in the past year.

Australian-domiciled emerging market funds top 10 as at April 2013

Source: Morningstar

It’s clear when comparing the tables above and below that post-GFC some managed funds have fared better than others. Colonial First State still has the top ranked fund, but Lazard’s Emerging Markets Equity I has fallen over the past five years from second place to tenth.

Australian-domiciled emerging market funds top 10 as at April 30, 2007

Source: Morningstar

The benefit of investing through a fund is that they can get access to markets that are out of reach for smaller investors. They also do all the legwork.

“It really is getting out on the ground, wearing out the shoe leather and visiting companies,” says Stuart James, senior investment specialist at Aberdeen Asset Management.

“For us, the real focus has to be on the companies because at the end of the day it’s the companies that you own that actually drive the performance of your portfolio,” he says. The strategy is obviously paying off. Aberdeen Emerging Opportunities Fund generated a 12.42% return over the past 12 months, compared with the MSCI Emerging Markets Index’s return of 4.65%.

As can be seen from the chart below, in Australia, domestic equities still account for a huge portion of the average investor’s portfolio, according to recent research by Vanguard. This is despite the fact that emerging equity markets account for just under a quarter of global equity market capitalisation and represent roughly 13% of global equity markets, compared with Australia’s 4%.

Click to enlarge

Source: Vanguard

Investors may prefer Australian equities due to their familiarity and exceptional dividend yield, but they aren’t the only answer. According to research by Citi, at the start of 2012, Australian equities were delivering a dividend yield of 5.1%. That dividend yield is now sitting at 4.1%. As lower interest rates force more people into the market, and companies will be forced to reinvest to deliver future growth, dividend yields will fall further.

There’s no arguing with the fact that sentiment towards emerging markets has been in decline in recent months, as markets in advanced economies have consistently outperformed. But for investors looking for longer-term growth opportunities and further diversification to reduce portfolio risk, emerging markets could be the answer.