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Emerging market funds for bulls and bears

Emerging markets are rallying, but if they turn you will need to be in the right fund to protect yourself
September 29, 2016

Emerging markets have languished in the doldrums for five years, but this year investors have flooded back into these markets spurred on by a hunt for yield, a slower-than-anticipated rate hike cycle in the US and political change in Latin America. But with the sector already riding so high, would an entry now be getting in at the end of the party?

The MSCI Emerging Markets Index has risen 31.3 per cent between 31 December 2015 and 20 September 2016, while emerging market bonds have set new records week after week as investors have piled in. And there are reasons to think the upswing has further to go, particularly as equities still look good value.

This month, the US Federal Reserve voted yet again to hold interest rates at record lows and, with negative yields across many other countries, the imbalance in yield is unlikely to shift any time soon. Many emerging countries are also in far stronger positions now, with lower debt to gross domestic product (GDP) ratios, more stable politics and lower dollar-denominated debt piles.

And unlike at the time of the 'taper tantrum' in 2013, emerging markets are looking cheap. Paul Jackson, managing director at Source, says emerging markets are now the cheapest assets in the world on a cyclically adjusted price/earnings ratio (PE) basis, and suspects they "have a good chance of massively outperforming over the next five years".

 

What could trip up the rally?

Despite those positives, emerging market economies remain tied to factors beyond their control. A hike in US interest rates or a strengthening dollar, for example, would result in money being pulled out of emerging countries. And a downturn in commodity prices would also take chunks out of emerging markets' performance: in the six months to April 2016, MSCI Emerging Markets Index was 94 per cent positively correlated with the oil price and 90 per cent correlated with the Bloomberg Commodities Index.

China also remains a concern. Although markets have taken their eye off the country for now, China's problems haven't gone away. The country is dependent on government spending for growth and its debt continues to grow. Jason Hollands, managing director at Tilney Bestinvest, says: "As policy support from the last round of stimulus fades, more fundamental cracks in the Chinese economic model may well return to the fore."

Finally, market surges built on political change are precarious. For example, MSCI Brazil Index is up almost 90 per cent in the year helped by the ousting of former President Dilma Rousseff, but little else has changed to justify that hype. As a result, Rob Marshall-Lee, manager of Newton Emerging Markets Fund (GB00BVRZK937)*, still does not have any assets in Brazil.

"We think political change in Brazil is good, but it does not sort out the underlying problems in the country," he explains. "People play the rally and these things get extended too far."

 

Watch out for double China exposure

Index provider FTSE is due to decide whether to add domestic Chinese A shares to its emerging markets index, which could result in a dramatic shift in the make-up of your emerging market fund.

China's highly restricted A share market is currently accessible to foreign investors through the Shanghai-Hong Kong Stock Connect programme, via which investors based in Hong Kong can trade A shares, or quotas awarded to institutional investors. But A shares could soon make up more than half of the FTSE Emerging Markets Index. That would mean that the China A share allocation of passive funds tracking the FTSE Emerging Markets Index would swell from just over 20 per cent to over half, and active managers would have to pay attention, too.

Until now, MSCI and FTSE have both rejected A share inclusion in their indices due to concerns over the transparency and liquidity of domestic Chinese markets, which have become synonymous with volatility and government intervention.

Managers have mixed views on whether they will bump up their allocation to A shares if they are included in the index. "We're pretty benchmark agnostic, so it wouldn't mean a lot," says Rob Marshall Lee, manager of Newton Emerging Markets Fund. "I've got two Chinese speakers in my team and we are actively looking at A shares, although do not yet invest. We've done a lot of work and have a shortlist of maybe five that we could invest in."

But China is taking another step towards broadening foreign investor participation with its Shenzhen-Hong Kong Stock Connect programme, which will open up its second-largest and tech-heavy stock market. The launch, expected to take place in November, means that investors based in Hong Kong will be able to buy and sell Shenzhen-listed A shares, giving them access to the high-growth, tech-themed names listed on that market.

 

Funds for pessimists and optimists

The best-performing fund managers this year are not necessarily the ones you want to put your money with if you are worried about emerging markets. The best-performing areas in the year to date have been Latin America, particularly Brazil, and value-orientated, higher-risk sectors such as Chinese banks, which you may well feel nervous about given China's ballooning debt. But if you want access to the funds with the fastest growth, a manager taking punchier, value calls could be the one for you.

Templeton Emerging Markets Investment Trust (TEM)* is value-tilted with exposure to a range of fast-growth themes, including technological disruption and genetics. It is undergoing a turnaround under new manager Carlos Hardenberg, who took over in October 2015 after the trust had lagged behind its benchmark for years. He is de-risking the portfolio by decreasing its concentration, and broadening exposure to new stocks and sectors. He is also moving away from large, well-researched blue-chip names in favour of undervalued mid-caps with good growth potential. New positions include Indian generic company Dr.Reddy's Laboratories (DRREDDY:NSI) as well as larger stocks such as South African media company Naspers (NPN:JNB) and Chinese internet giant Tencent (700:HKG).

The fund's performance has already turned and in the year to date it has returned 43.8 per cent against 33 per cent for MSCI Emerging Markets Index.

"The inclusion of smaller companies and those listed in frontier markets makes sense to us as it is a clear use of the investment trust structure, and a differentiator from its open-ended sister fund," say analysts at Winterflood. "Templeton has been known historically for its value approach and some will find this difficult to square with the inclusion in the portfolio of highly valued tech companies such as Tencent. Carlos Hardenberg acknowledges this and makes it clear that he has a more pragmatic approach to value investing that considers comparable valuations around the world."

JPMorgan Global Emerging Markets Income Trust (JEMI)* is tilted towards higher-yielding, lower-cost stocks and yields about 4.2 per cent. The trust underperformed last year due to its style bias, failing to beat its benchmark for the first time since its initial public offering in 2010. But it has rallied strongly in 2016 as the mood of the market has shifted away from quality, bond-like stocks towards favouring higher-yielding equities.

JPMorgan Global Emerging Markets Income has most of its assets in financials, which make up 24 per cent of its portfolio. In recent months, its managers have been selling holdings in Chinese financials, which have rallied strongly in 2016, as they think that the Chinese debt bubble could weigh on those stocks' dividend sustainability. These have been replaced with South African and Czech Republic banking stocks.

Although being forced to find income stocks restricts the trust's universe, co-manager Omar Negyal, says 1,142 stocks in his universe pay attractive yields, giving him ample choice. JPMorgan Global Emerging Markets Income has returned 37.5 per cent in the year to date and 44.1 per cent over five years, beating MSCI Emerging Markets Index.

More cautious managers who invest in high-quality companies include Mr Marshall-Lee, manager of Newton Emerging Markets. He favours high-quality growth stocks able to generate compounding returns year on year. Mr Marshall-Lee set up Newton's emerging markets team in 2011 and ran this fund for institutional clients until 2015, when it was offered to private investors.

It is among the top-performing open-ended global emerging markets funds over one, three and five years and is nimble, at just £77.75m in size.

The manager currently favours Indian stocks, including cinema company PVR (PVR:NSI), up 80 per cent in a year, and TAL education (XRS:NYQ) up several hundred per cent over the past couple of years. Mr Marshall-Lee also invests in Tata Motors (TATAMOTORS:NSI).

But he steers clear of Brazil and much of China, in particular Chinese banks and fixed-asset investments, which he thinks are vulnerable to a correction due to the enormity of China's burgeoning debt pile. However he does invest in Chinese internet companies.

"We still think India is where we will make the best returns in the next five years and the Chinese internet companies remain very positive for us," he says. "We are playing the conservative long-term game, so we don't take those high-risk bets."

That approach means the fund has not taken part in this year's rally to the same extent as other funds, which have profited from a surge in Chinese banking shares, for example. However it has managed to hold up this year returning almost 30 per cent against 33 per cent for the benchmark, and last year lost only 3.6 per cent when the market fell by 10 per cent.

"All in all, we believe Mr Marshall-Lee is capable of adding value over the investment cycle, providing investors with robust risk-adjusted returns," say analysts at Tilney Bestinvest.

JPMorgan Global Emerging Markets Investment Trust (JMG) has a quality bias and has been managed by Austin Forey since 1994, who has delivered consistent outperformance over that period. The trust aims to find long-term outperforming stocks and is willing to pay more for companies able to deliver growth regardless of tough macro environments. According to broker Stifel, the trust is trading on a valuation of 16.5 times forward PE, compared with 12.1 times for MSCI Emerging Markets Index. But Mr Forey says that represents good value in a growth-starved world.

Consumer staples feature heavily in this portfolio due to those companies' strong brands, solid balance sheets, cash flow generation and ability to command pricing power. Mr Forey also hold stakes in Chinese internet giants Tencent and Baidu (BIDU:NSQ), which he likes for their strong brand and disruptive business models.

Fidelity Emerging Markets (GB00B9SMK778) is a fairly defensive, though highly concentrated fund, which has demonstrated solid outperformance over the long term. Its manager, Nick Price, looks for quality, defensive companies that are able to perform throughout market cycles, and is most heavily invested in financial services, consumer defensive and consumer cyclical stocks.

"The manager isn't afraid to allow carefully analysed, punchy positions in the fund," say analysts at Tilney Bestinvest. "He is an accountant by background and scrutinises companies' reported numbers, working his analysts hard. We believe this is helpful in picking companies with robust business models, where share prices are typically more stable."

Over five years the fund has returned 61.3 per cent, comfortably beating MSCI Emerging Markets Index's 38.6 per cent return.

*IC Top 100 Fund

Shrinking emerging market debt

Some emerging markets have been shrinking their debt piles making them less vulnerable to global shocks and the impact of rising interest rates.

"Based on their debt fundamentals, emerging markets are better placed than most developed markets, which make the yield premiums on their bonds even more attractive," says Paul Jackson, head of research at Source. "Debt/GDP ratios in most emerging countries are well below global norms."

Those countries with low or shrinking debt piles include Indonesia, which has reduced its total external debt to GDP ratio by 32 per cent since 2000 so that it now stands at 34 per cent. And India's debt to GDP ratio is 120 per cent, compared to the UK's at 270 per cent.

Of the world's 20 largest economies, the ten most indebted countries relative to their economic output in 2015 (including governments, non-financial sector corporates and households) were all developed. "The most striking feature of our analysis is the relative lack of debt in emerging economies," says Mr Jackson. "Even China, which has been the focus of debt concerns in recent years, was less indebted than the global average in 2015. If investors are worried about debt in China they should really be worried about some other countries, in particular Japan, the Netherlands and France."

Debt is not the be-all and end-all. France and the Netherlands both have high levels of social spending and higher GDP than many emerging countries. However the research highlights the better structural position of many emerging markets than in the run-up to the so-called taper tantrum of 2013, when they reacted badly to a US rate hike.

"Macro conditions in emerging markets are much more resilient,"explains Alexis De Mones, head of fixed income at Ashmore. "When [Federal Reserve head Ben] Bernanke's tapering announcement caused the taper tantrum in 2013, the average current account in emerging markets was at a deficit of 2.1 per cent* Today external accounts in emerging markets are close to being balanced over the last 12 months, or in a surplus when one annualises the latest figures.

"This means that coming from a net debtor position three years ago, emerging markets are now becoming a net creditor to the rest of the world. This makes these countries much more resilient to an increased cost of funding in the US dollar system."

*(GBI-EM GD weighted current account deficit)

Total Debt/GDP (%) of world’s top 20 economies - top and bottom three 2015

Lowest 
Indonesia64
Mexico 71
Russia84
Highest 
Japan396
Netherlands326
France310

Source: Source, as at 26 September

Fund performance (% cumulative returns)

1m3m6m1yr3yr5yr10yr
Franklin Templeton Emerging Markets Investment Trust 0.623.530.444.56.018.2151.5
JPM JPMorgan Emerging Markets IT-0.419.822.638.425.250.8145.3
JPM JPMorgan Global Emerging Markets Income Trust -4.029.429.136.19.044.1
Fidelity Emerging Markets 1.120.419.434.528.561.3
Newton Global Emerging Markets 3.325.326.044.138.069.6
MSCI Emerging Markets Index2.525.722.436.719.338.6121.8

Source: FE Analytics as at 23.09.16