Investors are often spooked by the volatility that goes along with investing in emerging markets. Last year, political upheavals in Egypt lead to a dramatic plunge in markets, culminating with the closure of the Cairo stock exchange. But so far this year Egypt is the best-performing market, up 44.3 per cent year to date. Volatility is synonymous with risk. But with more risk, comes the possibility of greater reward. And for an individual savings account (Isa) investor taking a longer-term view - typically 10 years or longer, the additional volatility of emerging markets can reap attractive returns.
Structuring your Isa
Two of the most popular Isa fund purchases (according to figures from a number of fund platforms) in recent months have been Aberdeen Emerging Markets and First State Global Emerging Market Leaders Fund - two stalwarts in the emerging market space.
If you are considering an emerging market fund for your Isa, remember that an overwhelming number of these funds are growth orientated and above average risk so it is important that the fund fits with your risk profile.
Ideally you need a long time horizon - if for example you are investing in a Junior Isa for a newborn and the investment has a time horizon of 18 years to ride out market volatility, an investment in emerging market fund makes sense. "Emerging markets have all the dynamic for higher returns - the story is well known - growth rates in the region are much higher than in the developed world, the economies are more dynamic and faster changing. They are low cost but are rapidly becoming high tech and with the exception of China do not have the burden of an aging population," says Tim Cockerill, head of collectives research at Rowan Dartington.
The number of emerging market funds you hold within your Isa will depend on how much you are investing but bear in mind that the typical minimum lump sum investment in a fund is £1,000 while regular contributions will be £50 per month per fund.
Instant diversification
The beauty of a collective vehicle such as an open-ended fund or investment trust is that these provide diversification across a range of different companies and sectors and as such one fund could easily be sufficient within an Isa although this will depend on the total value of your portfolio.
"If the Isa represents a large part of the portfolio then careful consideration has to be given to the amount held in an emerging market fund. In this case one fund will be suitable and the investor should consider a fund such as First State Global Emerging Market Leaders which is managed cautiously and has one of the lowest levels of volatility within the sector," says Mr Cockerill.
Danny Cox, head of advice at Hargreaves Lansdown, agrees. He says if investors are looking to add an emerging market fund to their Isa portfolio it makes sense to hold a generalist fund such as JPMorgan Emerging Markets. "This is a good core choice and can be complemented by First State Global Emerging Market Leaders which is more conservatively managed or IM Hexam Global Emerging Markets which is much more aggressive," he says.
If your Isa is part of a larger portfolio then the entire Isa allowance could be invested in one fund or split between two. It is important to look at where the two funds are invested as there is likely to be some duplication. You should look to have funds with different investment styles to provide different dynamic within the portfolio.
Mr Cockerill suggests pairing up the First State Global Emerging Market Leaders and Templeton Emerging Markets Investment Trust (both short listed in the Investors Chronicle Fund Awards 2012 Best Global Emerging Markets Fund category). "Their structures are different and partly as a result of this their volatilities are very different too - Templeton is notably higher. They both seek quality stocks and are prepared to take the long-term view believing that quality companies on low valuations will perform well. The Templeton trust is, in my view, prepared to take a higher level of risk and as such compliments the cautious nature of the First State fund."
Investors can also adopt a core-satellite approach, placing a generalist emerging market fund at the core with a fund focused on specific emerging markets as satellite holdings. Market specific funds (also referred to as single country funds) are by their definition more focused and the returns will be entirely reliant upon one economy. Mr Cox says if an investor's portfolio is of a significant size and they want to take advantage of specific markets such as India or Russia which both look attractive at the moment, they could allocate more to a single country fund.
A cost-effective way to build a core satellite portfolio will be to add single country emerging market funds as your satellite holdings - these tend to be much cheaper than their open-ended counterparts. ETF providers such as iShares and db X-trackers offer a range of single country funds focused on emerging markets such as the iShares MSCI Chile Investible Index, iShares MSCI Turkey and db X-trackers MSCI Russia Capped Index ETF.
Fund analyst Glyn Williams says: "South Korea looks interesting (and the Pru reckon it is the best value versus expected return of their data), so you could access this via ETFs using iShares MSCI Korea, HSBC MSCI Korea ETF, CS ETF IE on MSCI Korea or db x-trackers MSCI Korea TRN."
Know what you're getting
Bear in mind, though, that emerging markets tend to be less liquid and indices can be weighted heavily towards certain sectors for example oil and gas or commodities. Investing in an ETF could also mean greater exposure to a company which makes up a large part of the index for example Petrobras in Brazil. Emerging markets is one area where a good active manager can add value by conducting regular company visits and management meetings and steering clear of higher-risk players.
Given the inherent volatility of emerging markets, Mr Williams says it can make sense to feed in your Isa contribution via regular payments rather than a one-off lump sump investment where you always risk getting your timing wrong.
But if you are intent on making a lump sum, Mr Williams suggest JPMorgan Emerging Markets subscription shares. "There are about £20m in issue, so the liquidity is not too bad, and the spread is reasonable; they offer good upside gearing in two ways: firstly against the share price and, secondly they would benefit from an improvement in investor risk appetite, if the shares catch up with the net asset value (NAV)."
He also suggests Neptune Global Alpha which has around two thirds exposure to emerging markets with 27.5 per cent in China and 23.7 per cent in Russia, as well as 7.3 per cent in Mauritius. "This fund can go to 100 per cent cash and is a fraction of the size of their global equity fund, so is very manageable by experienced manager, Robin Geffen."
Another way to access the emerging market story within your Isa would be a passive fund such as the Legal & General Investments Global Emerging Markets Index Fund. This fund does not have the same capacity constraints as active funds, and offers an effective means of achieving a global portfolio of emerging markets stocks across all of the key regions. As Mr Ellis puts it: "As the opportunity to access what may be considered the 'best funds' reduces, the importance of getting the 'best beta' will rise."
For more on Isas and what you can invest in see our Isas page.
