Profit from emerging markets

Emerging markets continue to prove alluring for investors and it is easy to see why. As developed economies struggle under the weight of monster budget deficits, which have required governments to implement harsh austerity measures, many emerging markets continue to boom. China may have recently set out a target for 7.5 per cent annual GDP growth in its latest five-year plan but its economy continues to outstrip that target – its latest GDP growth figure stood at 9.7 per cent in the first quarter. Other established emerging markets such as India and Brazil continue to grow strongly, powered by exports and, increasingly, burgeoning domestic demand.

Below the most recognisable emerging markets – Brazil, Russia, India and China (the so-called 'Bric' countries) – exists the next strata of emerging markets, including Turkey, Colombia, Indonesia and Vietnam, where the growth story is at an earlier, but no less exciting, stage. All investors should have some exposure to emerging markets and, with the increasing internationalisation of the UK stock market at all levels, there is no need to venture far from home.

The FTSE 100, with its heavy bias towards natural resources stocks, is effectively a global index rather than representative of the UK economy and even so-called British companies such as British American Tobacco and PZ Cussons now do a huge chunk of their business in emerging markets. Indeed, there are around 20 stocks in the blue-chip index that do virtually all of their business outside of the UK, many of which are focused on emerging markets. Some, such as Indian energy company Essar Energy and bank Standard Chartered , are focused entirely on emerging markets. And lower down the market the FTSE SmallCap index and the (Aim) are home to dozens of overseas companies which have been attracted to the London markets for prestige, the depth of capital and corporate discipline.

Any stock-picker looking for decent exposure to emerging markets can construct a portfolio entirely from London-listed shares that would encompass a wide range of emerging markets and also a wide range of industry sectors. This can be done easily without resorting to (GDRs), American Depositary Receipts or corporate bonds and (ETFs).

Beware the pitfalls

Investing in overseas companies still involves heightened risk. Not only is there increased corporate governance risk as you are effectively investing in a company that's at arm's length, but there is also the risk of government interference, and in particular the risk that a government will arbitrarily reclaim assets. Indeed, investors in the lower echelons of the market have become au fait with this sort of problem, especially with smaller resources companies, which are regularly embroiled in disputes over ownership of assets.

Take Madagascar Oil . When it floated on Aim late last year it had several oil and gas prospects in and around the east African island, only for the government to appropriate them within weeks. Fellow Aim stock Rurelec suffered a similar fate last year when the Bolivian government, with which it had joint ventured in the Guaracachi power generation business, renationalised the company overnight.

And such issues are not confined to the lower reaches of the market. Witness the problems encountered by First Quantum Minerals, the FTSE-100-listed Africa-focused miner. It has been dogged by a dispute with the government of the Democratic Republic of Congo, which cancelled the licence to one of its mines.

Not knowing what is happening on the ground due to the sheer distance involved is also a problem and can hamper an investor's ability to react quickly. Just last week, emerging markets fund manager Angus Tulloch of First State warned investors against betting too heavily on the emerging markets consumer in the coming months as he believes they are in danger of becoming overstretched. But this is something the typical UK retail investor on the other side of the world will have little feel for, with nothing to go on other than economic data from emerging markets.

As with any portfolio, investors should spread their emerging markets investments across countries, regions and industries to protect against the implosion of one particular sector or country.

Passive or active emerging market fund exposure

When investing in emerging markets, actively managed funds tend to be favoured over passive vehicles such as trackers or ETFs. The argument is that an experienced fund manager can navigate the dangers of these markets better, avoiding the more risky companies and countries while exploiting less efficient and under-researched markets and so deliver outperformance.

The data tells a different story, though. Between February 2006 and March 2011 the average emerging markets fund underperformed the FTSE Emerging index by 1.56 per cent, according to fund research company Morningstar and asset manager TCF Investment. The reason for this is charges. With a long-term investment such as a fund, consistently high charges chip away at returns – passive funds have substantially lower charges than their actively managed counterparts. An emerging market ETF will typically have a (TER) of around 0.6 per cent while most actively managed emerging markets funds charge between 1.28 per cent and 1.9 per cent.

Passive funds have other well-cited advantages. ETFs, for example, allow you to move in and out of markets quickly – with one trade you can own an entire index. And, although listed, ETFs do not trade at large discounts to (NAV).

Advocates of active funds point out that, although ETFs are cheaper, you will have to pay a broker fee on top of the management fee, which will add up for those who traded frequently or choose to make regular investments. Smaller ETFs and those investing in more esoteric assets that are less traded may have large bid-offer spreads – in some cases as high as 1 per cent – which will hurt when you sell.

Indices can also be more volatile. Emerging market ones are not always well balanced, with large companies sometimes accounting for as much as 15-20 per cent of the overall index. If one of these companies underperforms it could pull down the whole market.

A further point in favour of active management is the fact that most ETFs follow large-cap indices rather than small and mid-caps. But smaller companies and those biased towards domestic growth are particularly relevant in emerging markets, because these are more likely to capture (GDP) than a global multinational.

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