Emerging markets: time to re-enter?

"The discount in emerging markets valuations relative to developed markets is back to levels last seen in 2004 and, historically, this has represented an exceptional entry point for patient, long-term contrarian investors," says Slim Feriani, manager of IC Top 100 Fund Advance Developing Markets (ADMF). "While the Ukrainian crisis is yet another reminder of the risks that all investors must consider and be prepared to withstand when investing in emerging markets, we still see some interesting opportunities, particularly in Asia, where events such as the Indian elections may prove to be a strong catalyst for the markets."

It's not only managers of emerging markets funds who say there could be good opportunities. Alan Miller, director at wealth manager SCM Private, says: "If ever there was a time to invest in emerging markets, it's now. These markets are standing at five- to 10-year comparative valuation lows against their western counterparts while much of the earnings downgrades have taken place."

Other reasons to invest in emerging markets include positive developments on the corporate governance front and in earnings generation, which "have largely gone unnoticed", says Matthias Siller, manager of Baring Emerging Europe (BEE) Investment Trust. "The region is the most attractively valued among global equities, after having been consistently de-rated in recent years it now offers good growth opportunities. Dividend payout ratios have improved over the past couple of years, thanks to management teams and majority owners employing more shareholder-friendly policies. While we believe there is room for further improvement, dividend yields now rank among the highest globally."

"In the month to the end of March, activity data surprises were positive while inflation surprises were negative for emerging markets," adds Philip Saunders, portfolio manager and co-head of Investec Asset Management's multi-asset team. We have increased our exposure from a low base. While the macro news remains negative, we believe a lot is priced into valuations – not in every market, but in some. An example is India, which entered its difficult phase well before other markets. And negativity about China might well be overdone."

Risks

However, emerging markets are cheap for a reason as fundamentals continue to be poor, according to Rob Pemberton, investment director at HFM Columbus Asset Management.

"A run on several emerging markets currencies, rising interest rates and slowing growth has led investors in both equities and bonds to leave the area in droves for the more secure, developed western markets where economic growth is returning and the politics more predictable," he says. "Emerging markets investing tends to be dominated by the investor perception of China and this is currently a headwind.

"Emerging markets economies will continue to struggle in a world of continuing weak commodity prices and tightening global monetary policy, especially should the US dollar begin to appreciate again."

Emerging markets economies are less stable and less established, and good governance may be lacking. "In some countries such as Russia corruption is rife," says Paul Taylor, managing director of independent financial adviser McCarthy Taylor. "In others you can incur political risk, for example your investment may be nationalised or you might find your investments are in a war zone. The Russia/Ukraine tension threatens all markets but the less developed markets more, as investors will flee to safer havens if any form of military conflict erupts."

Andrew Milligan, head of global strategy at Standard Life, has been cautious about emerging markets for fear of value traps. "It is clear that a number of the issues facing emerging markets economies are deep-seated, while they vary from country to country, for example credit issues in Brazil are different to inflation problems in India," he says.

Emerging markets tend to be less liquid and therefore more volatile on a shorter-term basis. "They are also more prone to wild sentiment changes," adds Mr Miller.

And some investment analysts argue that despite the correction certain emerging markets sectors such as consumer staples stocks are still overbought.

But others argue that volatility is normal in these markets. "The real measure of risk is the likelihood of losing money rather than the average percentage daily change," adds Mr Miller. "If you buy an asset, such as emerging equities today, which combines a low valuation and a high likely growth rate, your risk is in reality fairly low. And many of the individual market/economy risks can also be substantially reduced through holding a spread of emerging markets countries rather than focusing on just one country or region."

Because of the risks, emerging markets are mainly suitable for investors with a high tolerance for risk and loss of capital. Mr Pemberton says they could also be suitable for medium-risk investors with a long-term time horizon if included in a well-diversified multi-asset portfolio, and that these could put between 3 and 5 per cent into emerging markets.

Mr Taylor believes those willing to take significant risk with their capital for possible out performance with a diversified portfolio could put up to 10 to 15 per cent of the equity element into this area.

Funds

You can access emerging markets via a broad global emerging markets fund, a regional fund concentrating on an area such as Asia or a single country fund. Mr Pemberton prefers regionally diversified global emerging markets funds investing across a wide number of markets which spread country-specific risk, as this can be very high in emerging markets for political or economic reasons.

He suggests IC Top 100 Fund Lazard Emerging Markets (GB00B24F1P65).

Source: Morningstar, as at 3 April 2014

But Mr Taylor argues: "Some emerging markets may represent a better opportunity than others. For example, over the long term we can see the advantage in being invested in China, already the world's second-largest economy. Although it has massive debt issues it has an enormous domestic market and the potential to be a new America.

But India disappoints because there is a lack of political will to drive forward the changes needed that will attract foreign businesses. Latin American countries have political risks associated with them which we think is being ignored in current pricing, although Mexico looks more inviting."

For this reason he prefers regional or country-specific funds.

You also have the choice of investment trusts listed on the stock market or open-ended funds. Some argue that investment trusts are better in illiquid and volatile markets as their managers can take a longer-term view as they do not have to meet investor redemptions. They can buy into out-of-favour areas and wait for them to improve.

There is also the potential to benefit from a double re-rating should markets improve – both the underlying assets and the investment trust's share price - and the potential for discounts to net asset value (NAV) to narrow. When markets are out of favour you may be able to pick up investment trusts which focus on them at a discount to NAV.

Some of broad-based global emerging markets investment trusts are trading on discounts slightly wider than their 12-month averages, as are a number of Asian regional funds, some on double-digit discounts. Examples include Fidelity China Special Situations (FCSS), which we tipped a couple of weeks ago on a discount of around 12 per cent in contrast to its 12-month average of 8 per cent.

"I have been picking emerging markets investment trusts lately because I think there is some value there," says Peter Walls, manager of fund of investment trusts Unicorn Mastertrust (GB0031269367). "Some of the Asian funds are on double-digit discounts and look attractive. If markets continue to stabilise discounts could tighten."

He has been buying into trusts including IC Top 100 Fund Templeton Emerging Markets (TEM), Pacific Assets (PAC), Fidelity Asian Values (FAS) and Aberdeen Latin American Income (ALAI).

However, investment trust managers can take on debt which boosts profits when the investments do well but exacerbate losses when they fall, making them in theory riskier.

"We use both investment trusts and open-ended funds," says Mr Taylor. "I think you need to be confident in the investment manager first and foremost, and look to see if trusts are on a discount or premium. Also consider the charges as cost is very important."

Mr Taylor suggests JPMorgan Chinese Investment Trust (JMC), also an IC Top 100 Fund, which he says has outperformed its benchmark over the longer term.

He also likes JPM Indian Investment Trust (JII). "The fund's managers target high-quality companies with good management and strong balance sheets," he says. "Key ratios such as price-earnings and price-to-book are below long-term averages they see as presenting opportunities for capital growth."

Also see our IC Top 100 Funds list for emerging markets funds suggestions.

Source: Morningstar, as at 31 March 2014

Active or passive?

It has been argued that because emerging markets are less efficient active funds are better for these than passive funds. And this is particularly relevant now, according to Mr Pemberton.

"The current opportunities in emerging markets are becoming increasingly apparent at the single company stock level rather than at the macroeconomic level, which should reward investors in funds with a proven stock-picking ability," he says.

Peter Walls, manager of IC Top 100 Fund Unicorn Mastertrust, adds that in emerging markets there are a number of companies that you wouldn't necessarily want to hold. "And the long-term numbers are impressive on some active Asian funds, for example the ones run by Aberdeen and First State," he adds.

However, Mr Miller argues: "It's a myth that active managers have done better at beating their benchmarks in emerging markets. Over the last 10 years to the end of last month, the average Investment Management Association (IMA) emerging markets fund has underperformed the FTSE emerging markets index by about 1 per cent a year.”

The choice of good active managers has become smaller as two of the leading emerging markets houses - Aberdeen and First State - have closed a number of their funds, and emerging market ETFs are also cheaper than emerging markets active funds.

Read more on using passive funds in emerging markets

Mr Taylor suggests that if you have a large enough portfolio to consider both active and passive emerging markets funds. "I would favour active where you can find a good track record, if not go passive."

Mr Miller says that there are huge variances in emerging markets returns so to take a low-risk approach you should diversify both by stocks and markets. He combines HSBC MSCI Emerging Markets UCITS ETF (HMEF), SPDR MSCI Emerging Markets Small Cap ETF (EMSD) and db X-trackers Harvest CSI300 INDEX UCITS ETF (RQFI) which tracks mainland China-listed 'A' shares.

Mr Taylor suggests iShares MSCI Turkey UCITS ETF (ITKY) to provide diversification within your portfolio, but cautions that it is only suitable for more aggressive investors.

Also see our tip on HSBC MSCI Turkey UCITS ETF (HTRY)