Is the emerging markets sell-off just a blip?

The rally, which was driven by the powerhouses of China, India and Brazil, led investors to pile into Asian and emerging market equity funds. According to figures from the Investment Management Association (IMA), there has been a marked upturn in money flowing into funds in its Asia Pacific ex Japan and Global Emerging Market sectors throughout the summer. More money flowed into Asian equity funds than into any other region in August. And the professional investors followed the same trend - a global fund manager survey from Bank of America Merrill Lynch in August found the number of managers buying into emerging markets had hit an 18-month high.

However, since the end of August there has been a significant sell-off in Asian and emerging market equities. Between 8 September and the start of October, the MSCI Emerging Markets index fell by 9.1 per cent, with none of the major constituent countries managing to avoid the rout.

The sharp sell-off has raised concerns, especially among investors who bought in August, over whether the summer rally was a flash in the pan or the start of a sustained recovery that has simply suffered a blip.

Ayesha Akbar, portfolio manager on the Fidelity Solutions fund of funds team, believes that the recent sell-off in the markets will continue to be the trend for the foreseeable future. She says the short term outlook for the region looks troublesome and advises investors that "it is time to take profits on emerging markets".

Ms Akbar says the rally seen in the summer did not come about due to any particular improvement in emerging market economies or companies and may simply have been because "valuations were so cheap". She also points out that there have been elections in several emerging market countries, leading to renewed hopes for reforms. This was especially evident in India, one of the best performing markets so far this year.

But Ms Akbar warns against betting too much on imminent reforms because it is much easier to promise improvements than to actually produce them, so the market may end up disappointed.

Some commentators have suggested that the expectation in the markets that the US Federal Reserve will raise its base interest rate next year has begun to spook the market. It is assumed that any such action will have a disproportionately negative impact on emerging markets, many of which still rely on capital flowing in from the West. Ms Akbar thinks the rate rise is already priced in and the emerging markets sell-off is simply based on the poor long-term outlook for the region.

However, Edward Lam, manager of the Somerset Emerging Markets Dividend Growth Fund (GB00B4QKMK51), thinks that the current level of the market should be an attractive entry point for long-term investors. He admits that "in the short term there are not many things to suggest a turnaround" but insists that in the long term emerging markets should bounce back.

He points out that the current period of underperformance relative to developed markets, which can be dated back seven years, is one of the longest recorded and has left the region significantly cheaper than developed markets. And while cheaper doesn't necessarily mean better, Mr Lam thinks the environment is looking rosier for emerging markets.

He explains that when developed markets cut spending, reducing their budget deficits, emerging markets have historically been badly hurt. This has been happening in the past several years of 'austerity.' But Mr Lam thinks most countries now have their deficits under control and could start to raise spending soon, which will lead to a boost for emerging markets.

Gavin Haynes, managing director of discretionary management firm Whitechurch Securities, says any investors targeting "long-term capital growth" should have a stake in emerging markets. He also thinks that the current environment is a good entry point because "at current valuations many of these markets look cheap relative to their longer-term averages". But Mr Haynes acknowledges the volatility of investing in emerging markets, which has been seen in recent weeks, and suggests investors drip feed money into the region if they wish to reduce volatility.

Andrew Alexander, head of investments at independent financial adviser (IFA) firm Three Counties, agrees that "the case for emerging markets is still there", but thinks investors "need to be highly selective" in terms of which regions and countries they focus on. He explains that investors "need to focus upon economies and regions where political reforms are occurring" while also focusing on countries in which the companies are enjoying strong earnings growth. He tips India as one region that investors should look to get access to, because it combines good businesses that are growing earnings with a reformist government under new prime minister Narendra Modi.

The long-term case for investing in emerging markets is known to many, if not most investors. Most emerging market countries are growing faster than the developed world, many have huge untapped resources in terms of demand and the emergence of affluent middle classes should trigger a huge rise in spending power. But while investors in for the long haul should no doubt benefit from these trends, there is no evidence currently that a rally in Asian and emerging markets is set to take place imminently.

The summer rally may not have been something as transient as a flash in the pan, but it can at best only be described as the opening sparks of a long-term rally in which cheap emerging market stocks will eventually emerge. But investors could face further downward pressure before this rally really kicks into gear.

Best emerging markets funds

Investors looking for the best access to emerging markets in the UK will struggle to find many accessible funds with long track records. This is because some of the best-performing funds, from the likes of First State and Aberdeen, have been closed to new investors.

But a more recent launch, Fidelity Emerging Markets Fund (GB00B9SMK778), has quickly grown in popularity thanks to its very strong performance since launch in 2010. Mr Alexander says that he favours this fund, which is managed by Nick Price, in his portfolios for clients. He cites Fidelity's "use of its global resources and its best ideas approach" as reasons behind the fund's success. He says: "They gather the ideas from each of the main global emerging markets regions (Latin America, emerging Europe, south-east Asia and China) then Mr Price will select the best ideas from each of these to populate the portfolio."

Also read the IC tip on this fund

But in a short-term environment, characterised even by emerging markets managers as one of uncertainty and volatility, a more defensive strategy could literally pay dividends for investors. Emerging market equities have slowly turned into an interesting option for income-seeking investors; one that is currently under-appreciated. The MSCI Emerging Markets index currently has a yield of 2.7 per cent, greater than that of any index in the US or Japan. Income-generating stocks tend to be better at weathering volatility because they need a strong balance sheet and sustainable and predictable cash flows in order to produce a strong and growing yield. So for investors worried about emerging market volatility, Whitechurch's Gavin Haynes suggests JPM Emerging Markets Income Fund (GB00B50VRT53). The fund, which is managed by Richard Titherington, is another recent launch having come to market in 2012, but it has performed solidly since inception and its 5.07 per cent yield is attractive in the current low interest rate environment. Its manager also runs IC Top 100 Fund JPMorgan Global Emerging Markets Investment Trust (JEMI) which has a yield of 4.12 per cent and is trading at a 2.54 per cent premium to its underlying net asset value.

The Brazilian market has suffered terribly in recent weeks, while Russia has predictably struggled in the face of sanctions and the prospect of conflict with the west. So for investors looking to just focus on the Asian side of the market, Hermes Asia ex Japan Equity Fund (IE00BBL4VQ02) offers a value driven approach that could pay off handsomely given the cheap valuations in parts of the region. Investment consultancy firm Square Mile Investment Consulting and Research recently added this fund, managed by Jonathan Pines to its 'academy of funds' recommended list. Square Mile consultants believe that the fund is "truly doing something different compared with many of its peers" in that the team's investment philosophy has an "inherently contrarian and value bias".

With many funds in Asia and emerging markets obsessed with looking for growth, Mr Pines' fund offers a different way to invest in the region. The style has worked well so far as it is the best performing fund in the IMA Asia Pacific ex Japan sector since its conversion to a format available to UK retail investors in December 2012.

For investors looking for a fund with a longer timeframe on which to judge performance, you can't get much longer than IC Top 100 Fund Templeton Emerging Markets Investment Trust (TEM). This pioneering investment trust has been run by Mark Mobius since 1989 and has built up an impressive track record. Performance in the past three years on the trust has been disappointing, but the experience of Dr Mobius and his team is unparalleled, and the trust's discount of 9.15 per cent is tighter than its 12 month average discount of 10 per cent.

Emerging markets are sometimes referred to as one of the areas of the equity market where it is better to use an active manager, along with areas such as smaller companies. The idea is that trackers make more sense in efficient markets, such as the US, where it is hard to get an information advantage. Emerging markets are seen as inefficient and therefore ripe for active managers.

But the flipside of inefficiency is that it is just as easy for a manager to get an active bet wrong than right. There are actually very few UK domiciled emerging markets funds that consistently outperform.

For investors seeking a low cost passive way to access the markets, the Vanguard FTSE Emerging Markets ETF (VFEM) is one of the best options, with a total expense ratio of 0.25 per cent. But for those looking for an open-ended tracker fund alternative, Mr Haynes suggests BlackRock Emerging Markets Equity Tracker D Acc (GB00B84DY642), which has an ongoing charge of 0.26 per cent and aims to track the FTSE Emerging Index.

Performance of recommended emerging markets funds

Source: Morningstar, as at 3 October 2014