Despite their recent poor performance, over the last five years both portfolios have benefitted from their emerging markets exposure - particularly in the Far East. Back in early August, I topped up the Growth portfolio's exposure but space in last month's column did not allow me to explain why.
The case for emerging markets
First the doom and gloom. Emerging markets have recently had a torrid time. The economic fundamentals have been deteriorating. Growth rates have been downgraded - there being particular concern about China given its size. Worsening finances have also checked enthusiasm. Many emerging market current account balances have moved into deficit this year.
In addition, uncertainty regarding the extent and speed of the Fed's plans to taper its monetary stimulus - the perception being that these markets have disproportionately benefited from this easy money - have not helped. Add in concerns about the lack of structural reform in many of these countries, and it is not difficult to see why sentiment is so negative.
Stock markets reflect this pessimism. Various measures confirm the extent of their underperformance, and that they now trade at a significant discount to their more established peers. Back in 2007, the cyclically adjusted price/earnings ratio (Cape) for emerging markets as a whole was around 30 times. That figure has now fallen to around 14 times - which compares well with the US which is on around 25 times.
In short, a lot of the bad news is in the price. Sentiment is very depressed. Now this would be less significant if it was not for the fact that, despite past enthusiasm, investors tend to be underweight emerging markets. For all the talk about the relative attractions, particularly when compared to the debt-ridden West, investors remain cautious. As a result, they have missed a great growth story over recent decades.
A key reason for this underweighting is volatility. Investors understandably do not like it. It makes for sleepless nights. But for those investors willing and able to take a long-term view, volatility should be embraced and exploited. As I have emphasised in my recent book, if volatility is a measure of risk then investors would always be underweight good opportunities. The debate should be more about timing. Short term, only a gifted few know where these markets are heading. But longer term, I suggest they represent compelling value. Investors should therefore view recent volatility as an opportunity and not a risk.
The outlook for emerging markets is not as dire as the market assumes. Growth forecasts may have been cut but they are still healthy. Some estimates suggest 4.5 per cent this year and 5 per cent next - developed markets' growth is anaemic by comparison. Despite deteriorating finances, they still compare favourably with the West.
Meanwhile, there are tentative signs in a number of countries that structural reforms - needed to sustain growth over the longer term - are attracting greater focus. Furthermore, a host of other factors, less tangible but still meaningful, including younger populations, all merit optimism.
In short, sentiment trails fundamentals. The extent of the recent underperformance presents long-term investors with a rare opportunity. As if to illustrate the point, a recent note from Citi suggests that these sort of emerging market valuations have predicted positive returns for all big equity markets over the following year in nearly 90 per cent of the time.
Now is the time to start building positions - particularly for those investors still underweight the sector. With valuations unduly depressed, investors are fortunate to have a second chance at profiting from the emerging market story. Seize the moment.
But how should one best do it? I would caution against investing in the large mainstream or generalist investment trusts - unless you have the smallest of portfolios. Not because they are no good - quite the contrary - but because I suggest better opportunities exist within the more specialised sectors and strategies as represented by existing holdings in the Growth and Income portfolios.
I prefer Asia to Latin America over the longer term. Better valuations relative to growth rates, high saving ratios and a rapidly emerging middle class are just some of the attractions.
Linked to this, exposure to smaller companies is important, hence the existing holding Aberdeen Asian Smaller Companies trust (AAS). Faster growing economies do not always result in good stock markets - as investors in China will testify over the last decade. But this fact risks missing a more important point - faster growing economies provide a richer pool from which good fund managers can fish. And this is particularly true of smaller companies, as highlighted by past performance.
Another strategy I prefer is income, hence JPMorgan Emerging Markets Income trust (JEMI) and iShares DJ Emerging Markets ETF (SEDY). This is as good a way as any of navigating through the corporate governance issues - improving though they are. Furthermore, given the continued outlook for low interest rates in the West, the search is on for overseas yield. And emerging markets are obliging, particularly in the Far East. It is estimated that Asia now has one-third of all equities yielding 4 per cent plus. Investors are spoilt for choice, and the good trust managers again are having a field day, hence Schroder Oriental Income trust (SOI).
I also like the infrastructure story, hence Utilico Emerging Markets trust (UEM). The need for governments to cater for better infrastructure both to nurture economic growth and cater for their expanding and increasingly expectant middle classes is profound. In some countries, governments are playing catch up - and there is a political incentive to do so.
Finally, I'm a fan of frontier markets, hence BlackRock Frontiers trust (BRFI). Faster growing economies, young populations and a huge emerging consumer-facing middle class are just some of the factors which point to great potential. This is particularly the case for those investors willing to seek out opportunity. The stock markets are still in their infancy. They are under-researched and stand on attractive ratings relative to both developed and emerging markets, given their growth outlook. Indeed, I suggest these markets are where emerging markets stood a generation ago. Lower volatility and weight of money arguments are also in their favour.
So pick your sectors and strategies. Accept short-term volatility as an opportunity, knowing these markets represent good value today on a longer-term view. And start building positions, particularly if underweight - second chances do not come along every day.
There were no changes to either portfolio during September. Meanwhile, I look forward to meeting more readers at the next Investors Chronicle seminar on Specialist Investment Trusts on 29 October.
View John Baron's updated Investment Trust Portfolio.
