Warning as investors flock to emerging markets

For the second month running, the Global Emerging Markets sector was the best selling Investment Management Association (IMA) sector in November, with net retail sales of £337m into open-ended funds, the highest month on record.

The surge of money into Global Emerging Markets funds comes on the back of 10 years of strong performance. There is also a coalescence of opinion that this represents fund investors' growing comfort with diversification beyond their home borders, with investors holding much more diversified fund portfolios across global equities than ever before.

Among investment trusts, emerging markets had a particularly strong 2010 and a poll of investment trust managers by the Association of Investment Companies found that Emerging Markets (20 per cent) is once again the favoured sector for 2011. The prominence of emerging and frontier markets has been evident in the new investment company launches in 2010.

Active fund managers may be optimistic about emerging markets but among less interested parties warnings about chasing performance in emerging markets are growing in volume. The latest is from Vanguard, the pioneer of index-tracking strategies and now one of the world's largest investment management companies, with $1.7 trillion (£1.09 trillion) in assets.

Vanguard's research shows that the widely-held view that emerging economies will grow faster than developed markets, and that their financial markets will therefore outperform developed markets, may be wrong. "The problem with this simplistic cause-and-effect relationship is that it ignores history and the price paid for future growth," says Jeff Molitor, Vanguard chief investment officer for Europe.

"Looking back over the past 10 years, emerging markets investors were rewarded not because of economic growth per se, but rather because of comparatively low equity valuations in the early 2000s coupled with consistently higher than expected economic growth throughout the period."

Other studies, such as the Credit Suisse global returns yearbook, have concluded that historically, emerging markets' superior performance has been largely a reward for assuming additional risk.

Intuitively, because emerging markets are riskier than developed markets, they should trade at a relative discount. But, today, Vanguard says valuations in UK and emerging markets are at relative parity, suggesting that the case for continued outperformance of emerging market equities may not be as concrete as either past returns or projections for future economic growth would suggest.

Emerging markets versus UK equities

Data to 30/11/10 (£)UK equities (%)Emerging markets equities (%)
1 year9.721.9
3 years-1.27.3
5 years4.015.3
10 years2.514.6

Notes: Data reflects the performance of the MSCI UK Index and the MSCI Emerging Markets Index on a total return basis.

Source: Vanguard Group, based on data from Thomson Reuters Datastream & MSCI.

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