Recycle your profits into emerging markets funds

The abysmal performance of emerging markets shares has disappointed investors everywhere. DIY investors in the UK were spooked by the tumbling valuations in emerging markets, and their fears were crystallised by professional wealth managers, many of which sold out of emerging markets, too. Billions of pounds were pulled out of the region in 2013.

But the chasm between the performance of emerging markets and developed ones now presents an ideal opportunity for balanced investors to rebalance their portfolios by recycling their profits from developed markets into emerging markets.

Equity valuations in emerging markets are on the floor, and as such present a buying opportunity for contrarian value investors. Growth in the major emerging market economies may have slowed, but the long-term forecast growth rates for emerging markets still remain well ahead of those of the developed markets.

Why emerging markets look like good value

Since late 2010, something unusual has happened to the valuations of emerging market stocks. A disconnect between their performance and their actual underlying earnings has grown, especially when compared to developed markets.

This decoupling of prices from actual delivered earnings can be explained by investors' growing pessimism about the long-term earnings potential in emerging markets. However, forecasts suggest these fears are unfounded. For example, bottom-up IBES forecasts for 2014-16 (a compilation of estimates made by stock analysts) expect a healthy annual earnings growth of 10.9 per cent.

Despite this, 12-month price-to-earnings (PE) ratios in emerging markets are well below major developed markets. Currently, global emerging markets trade on just 10.7 times, which represents a 28 per cent discount to global developed markets, according to research by AXA Rosenberg.

Jonathan White, deputy head of client portfolio management at AXA Rosenberg, says: "The fundamental data we observe indicates that emerging market equities are available at very attractive levels, both in absolute terms and relative to developed markets. The unprecedented decoupling from developed markets that we have noted is not underpinned by an earnings collapse, and as such the prospect of a rerating from here looks feasible given the macroeconomic improvements that are already under way."

Global stock valuations

Optimism is growing around emerging markets

Predictably, as emerging markets have begun to show signs of bouncing back, streaks of optimism are returning among some investors. More than a quarter (26 per cent) of independent financial advisers now view emerging equities as "very favourable", up from 14 per cent in the last quarter, according to Baring Asset Management.

Even the most experienced investors are adamant that there are still profits to be made in emerging markets. Terry Smith, the veteran City broker, is so confident about the sector that he launched a new investment trust (Fundsmith Emerging Equity Trust (FEET) last month. The launch raised £193m and the shares went straight to a premium over their net asset value.

But there are still considerable threats looming over emerging markets - making them a risky investment. Professional investors are increasingly concerned about the impact of China on the global economy, with 58 per cent warning that slowing growth will be a major macro-economic threat over the next six months, according to Baring's research. The fund house also says that 56 per cent are now even more worried about the impact of the Russia/Ukraine conflict than the eurozone growth problems and overleveraged economies' ability to reduce debt.

But risk factors such as these should not necessarily be a reason to feel pessimistic. They should be expected, as they are the reason why these countries are labelled as "emerging" and not "developed", says Emily Whiting, client portfolio manager at JP Morgan Asset Management.

Which funds to buy

If you're looking to increase your exposure to emerging markets, investment trusts should be your first port of call. Trusts have a long-term track record for delivering superior long-term performance in developing countries, compared to open-ended funds such as Oeics (open-ended investment companies) and unit trusts. This is due to their closed-ended structure - they don't have to buy and sell assets to meet investor demand - and their ability to borrow to invest. Most emerging markets investment trusts are trading on wide discounts to their underlying net asset values (NAVs), a price advantage that won't last if sentiment in the region improves drastically.

If fact, they are already narrowing, suggesting that now could be a good time to snap up a bargain. The average discount is 7.1 per cent, down from 10.3 per cent a year ago and 8.9 per cent when emerging markets began to suffer three years ago, according to data by Morningstar.

If you're investing in emerging markets for the first time, Ms Whiting recommends avoiding single country funds. "You need to be very confident in a country, indeed, if you want to concentrate your risk there. You also need to be prepared to take on a high level of volatility. Most people re-entering emerging markets or investing for the first time would be better off drip-feeding money into a broader fund, to match their regaining confidence in the region as a whole," she says.

We like BlackRock Emerging Europe (BEEP), which earned a place on our list of Top 100 Funds for 2013. It lost 12.7 per cent over three years (to 25 June 2014), but over one year it has managed a 13.3 per cent return. It has consistently beaten the AIC European Emerging Europe markets sector, which has returned 59.1 per cent over five years, compared to 72.4 per cent from the trust. Last year, it changed its investment policy and reduced the number of holdings from 45 to between 20 and 30 to allow it to look beyond large companies which dominate its benchmark, and to choose the best ideas in its investment universe instead. The trust's recent outperformance suggests this new approach might just be paying off. It is currently trading on a 9.4 per cent discount, which is slightly wider than it was in 2011, at 8 per cent.

JPMorgan Emerging Markets Trust (JMG) is also a top performer over the long term. Over 10 years, it has returned 334 per cent - more than every other emerging markets investment trust apart from Templeton Emerging Markets (TEM), which returned 360.9 per cent over the same period. However, the JP Morgan Trust is trading on a 10.1 per cent discount, almost double that of the Templeton Trust. The trust is heavily invested in India (18.0 per cent), a region which analysts are confident about because of the recent election of a new leader. The new prime minister, Narendra Modi, has a strong track record of delivering positive economic policies. It also has large allocations to Brazil (15.0 per cent) and South Africa (11 per cent). The TER is reasonable at 1.14 per cent.

Another way to get exposure to emerging markets is to buy a bond fund. Emerging market debt is becoming an increasingly popular option for private investors, and there are two reasons for this. The first is that bond funds tend to be less volatile than equities and suit people who want to diversify their portfolio without suffering harsh peaks and troughs. And the second reason is the yields on these funds, which average around 5 per cent, as well as giving investors the chance of growth.

We like Aberdeen's Emerging Market Bond Fund (GB00B5BV9P41), which is a first-quartile performer within its peer group (IMA Global Emerging Market Bond). The fund has an approach to currency risk management that will suit investors looking to reduce volatility as, unlike its competitors, it is only 15 per cent exposed to emerging markets currencies and 85 per cent exposed to sterling. But don't confuse volatility with risk - as this fund has a high-risk rating and is not for the faint-hearted. It has a TER of 1.65 per cent and pays a healthy yield of 5.12 per cent.

Performance of emerging market indices

Source: Morningstar, *to 25 June 2014.

Share price performance and price discounts of emerging market investment trusts

Source: Morningstar, *to 25 June 2014.