Emerging market funds for your Isa

Emerging market funds' standout performance has wobbled over the past year. Since peaking in October 2010, the MSCI Emerging Market index has underperformed the MSCI World index by 15 per cent. But Alan Brierley, director of investment companies at Canaccord Genuity, says this is yet another reason why now is a good time to snap up good value funds for your portfolio. "Given the performance record over the past decade, it was inevitable that emerging markets would pause for breath. However, the recent period could represent an attractive buying opportunity."

Demographically, western countries are being dwarfed by emerging markets, but the headcount is the limit of their dominance - for now at least. Emerging markets are still largely controlled by inflows of western money, so when we pile money in, we drive the price one way: up.

This means emerging markets have "looked cheaper", according to Adrian Lowcock, senior investment manager at Hargreaves Lansdown. But it's not all bad news as other factors suggest now is a good time to buy.

The weakening pound is actually good news for those making overseas investments. This is particularly the case in emerging markets, where currencies are steadily strengthening.

Darius McDermott, financial planner at Chelsea Financial Services, said: "The UK's AAA downgrade means it's unlikely the pound will make a rebound any time soon, but emerging markets' currencies are looking stronger and stronger, meaning you can make your pounds stretch further by investing in them."

And Mr Lowcock expects emerging market currencies to rise strongly against sterling, which will benefit investors as any currency appreciation will boost investment returns.

However, he also warns that currency is a potential risk. Currency movements can affect the volatility of underlying asset classes and fund managers tend not to try to predict currency when investing overseas. This is simply because most believe that they don't have the necessary skills.

Consider the big picture

Taking a moment to view the macroeconomic landscape is vital if you're considering emerging markets for your Isa. Data from the Investment Management Association (IMA) reveals that private investors are directing more than 220 times more money into emerging market funds than they were a decade ago, and they are still the fastest-growing economies in the world - three-quarters of 2013's global growth is predicted to come from emerging markets.

The demographics are startling. According to law firm McKinsey, by 2020 the number of households in China with a disposable income between $16,000 and $34,000 will increase 10-fold to 167m. And the International Monetary Fund (IMF) forecasts emerging markets' total GDP could overtake that of the developed economies in 2014, while China's purchasing power is expected to surpass the US's by 2016.

It's easy to be dazzled by bewildering headline statistics, but it's important you thoroughly research the area and the sectors you'll be exposed to and feel confident they are set to do well.

How much should I invest?

If you already have a diversified equity portfolio, there's a strong possibility you've already got emerging markets exposure in your Isa.

FTSE 100 companies rake in nearly a third (27 per cent) from Asia and emerging markets. This chunk has risen from 23 per cent in 2008, and a weaker pound should further boost the bottom line, says James Butterfill, equity strategist at Coutts. So if you're invested in UK large-caps, it's worth bearing in mind that the region is already likely to have a significant impact on your returns.

And if you do decide you want to invest directly, it's important not to bite off more than you can chew. Cautious investors could consider giving 3 per cent of their portfolio to emerging markets; medium-risk investors should not exceed 6 per cent; while high-risk investors should call it a day at a 10 per cent allocation.

What about frontier markets?

Frontier markets are all the rage, but they come with a level of risk only racier investors should feel comfortable with. With China channelling investments into many of these markets, Africa in particular, frontier and emerging markets are increasingly entwined. Armed with a young and cheap labour-force and rich in minerals and natural resources, Africa is fast becoming a manufacturing haven to support the Chinese middle classes' material demands.

Michael Paul, analyst at City Asset Management, says investment trusts are the best way to go if you do decide to stick your neck out, because the markets are so illiquid. And investment experts recommend an allocation of around 1 per cent of your portfolio - and insist on frontier funds as long-term-only plays for your Isa.

EMERGING MARKET FUND IDEAS FOR YOUR ISA

Open-ended fund with high income

Charlemagne Magna Emerging Markets Dividend (ISIN: IE00B670Y570)

If you're on the hunt for income, the Magna fund is one of the best. It has delivered an average yield of 5 per cent - in the top range of what you'd expect from emerging markets. The high level of income means it's a great pick for your Isa as it'll help you take full advantage of the tax breaks. As it's run by an investment house dedicated to emerging markets, you can rest assured its managers really know what they're doing. It has recently benefited from avoiding consumer staples (which look overvalued), but has cashed in on a Mexican housing fund, for which demand has rocketed.

Medium-risk defensive China exposure

First State Asia Pacific Leaders (ISIN: GB00B54S3722)

This open-ended fund comes highly recommended by analysts. It has around 30 per cent invested in China and provides a diversified way to access the nation. Managers Angus Tulloch and Alistair Thompson continue to maintain their defensive position and focus on value companies which have pricing power, strong cash flows and low debt levels. This fund cashes in on the traditional China consumption story.

High-risk emerging markets fund with frontier exposure

CF JM Finn Global Opportunities Retail (ISIN: GB0034116870)

If you're tempted by frontier markets' staggering potential, but only feel ready to dip your toes into the water, this fund is worth a look. It's a global fund from which around 25 per cent of revenue is generated by companies that operate heavily in Africa, but are listed on western markets rather than local exchanges. The fund has returned an average of 10.2 per cent a year and an impressive 13.2 per cent over the past 12 months, but really suffered during the financial crisis because it was heavily exposed to commodities before the crisis, which caught out the manager. This is not a fund for the faint-hearted.

Very high-risk China exposure

Jupiter China (ISIN: GB00B1DTDY55)

Risk-wise, investing in a single-country emerging markets fund is like putting all your eggs in one basket. But if you're confident it will serve your investment expectations, there's no reason why you shouldn't take the plunge. This fund has a bias towards smaller and medium-sized companies in the domestic Chinese market. This means you'll have a bumpier ride than with other funds. But after a long period of poor performance, it appears to offer good value. A focus on consumer stocks, construction and environmental technology means the volatility is likely to continue, but if you're bullish on China, this is exactly the kind of exposure you want.

Higher-beta exposure to emerging markets

Templeton Emerging Markets Investment Trust (TEM)

After several years of material outperformance, global emerging markets have lagged behind in the past couple of years and this fund's fortunes have typically been closely correlated with them. But Templeton Emerging has added significant value over the long term. It outperformed the benchmark and average global emerging market unit trusts by an annualised 2.7 per cent and 3.8 per cent, respectively, over 10 years. Its manager, Mark Mobius, focuses on three key characteristics of emerging markets; high economic growth rates, large amounts of foreign reserves and low foreign debt. And he also says many emerging economies appear on the cusp of consumer booms as well as productivity advances - and these should bode well for future growth potential. The trust is currently trading at an 8 per cent discount to its underlying net asset value.

Experienced Asian stockpicking

Edinburgh Dragon (EFM)

This investment trust is in a strong position, according to Mr Brierley. Crucial to its success, he says, is its highly regarded management team, which has tried-and-tested investment processes and impressive long-term track records. With a market capitalisation of £553m, the Edinburgh Dragon is the largest of the Asian investment trusts. Over five years, the fund has thumped rival trusts with a NAV total return of 61.5 per cent. The management fee of 1 per cent of net assets is excellent value compared with comparable open-ended funds and its shares have traded on a discount of between five and 10 per cent for most of the past four years. It currently trades at a 6 per cent discount to its underlying net asset value, but Mr Brierley is expecting this to narrow.

iShares Emerging Markets Minimum Volatility ETF (EMMV)

If you want some cheap exposure to emerging markets, an exchange traded fund (ETF) could be your best bet. The iShares MSCI Emerging Market Minimum Volatility ETF aims to achieve a return on your investment, through a combination of capital growth and income on the fund's assets, which reflects the return of the MSCI Emerging Markets Minimum Volatility Index, the fund's benchmark. The fund invests in shares that, so far as possible and practicable, make up the benchmark index.

Stock markets are notoriously volatile, but The MSCI Minimum Volatility indices help to counteract this, giving you a smoother ride. They optimise the respective parent MSCI Indices, which are capitalisation-weighted, by determining weights for securities in the indices with the lowest total risk. Index constraints such as country, sector and style exposures are applied to the optimisation to ensure diversification, while broadly matching the profile of the corresponding cap-weighted MSCI index.

With a total expense ratio of 0.4 per cent, this ETF is significantly cheaper than the recommended open-ended funds and investment trusts.

Recommended funds' performance data