A number of analysts are warning that emerging markets funds don't do what they say on the tin because the stock selection of their benchmark indices are about 10 years out of date. And the developed market stocks hiding in your portfolio could be the cause of the recent poor performance of emerging markets funds. But are they really that bad for returns?
Emerging countries that some experts believe should really be classed as 'developed', including South Korea and Taiwan, have been tucked away in fund managers' portfolios for years. They are also some of the biggest components of the MSCI Emerging Markets index, with a 15 per cent and 12 per cent allocation, respectively.
Both South Korea and Taiwan are due for an upgrade review for 'developed nation status' in 2014, meaning funds would gradually start ditching them from portfolios if they qualify. But despite high GDP and other credentials that mean some analysts already think of them as developed, not everyone thinks they are misplaced in emerging markets funds.
Mark Mobius, emerging markets fund manager at Franklin Templeton, says institutional investors are losing sleep over idiosyncrasies in their foreign exchange markets and stock identification systems causing South Korea and Taiwan to fail the market accessibility test. "We feel that the South Korean and Taiwanese economies are so intimately meshed with their emerging neighbours that their presence in emerging market indexes currently makes good sense," he said.
And he highlights that the tables can also turn the other way. For example - thanks to its recent economic woes making it a tricky market for foreign investors to bite on - Greece will soon become the first country to be downgraded from 'developed' to 'emerging' by MSCI.
But the kind of investments in these 'developed-ish' regions don't fit with the traditional emerging market investment stories often told by fund houses.
The typical image that attracts emerging market investors is of exponentially growing flocks of Chinese ladies practically banging down the doors of Louis Vuitton and Burberry to get their hands on the latest handbag or trenchcoat.
Indeed, this is where some of investors' money goes, but for emerging market funds with heavy exposure to Taiwan and South Korea, a large chunk of their stocks are likely to veer sharply from the common rising middle-class luxury consumption idea.
Simon Edelsten, manager of the Artemis Global Select fund, says these countries, which are on the cusp of being developed, aren't a total disaster for emerging market investors. But he describes the key stocks in these regions - mainly consumer electronics companies such as Taiwan Semi-Conductors - as "not terribly exciting", and says heavily invested funds' returns might have been dampened as a direct result of their exposure.
But a quick glance at pure Taiwan funds shows they haven't actually been doing that badly. In fact, some of them have been doing rather well - JPMorgan's offshore Taiwan fund (ISIN: LU0210528419) has returned 20.05 per cent over the past year - a significant trump on the MSCI index tracked by db-x tracker’s Taiwan ETF (Ticker: XMTW), which has returned 12.29 over the same period. And when it comes to South Korea, there's only one fund available to UK investors - Baring Korea Trust (ISIN: GB0000840719). Its performance hasn't exactly been spectacular - managing 6.1 per cent over a year and 15.3 per cent over three years - but it hasn't lost money either.
Some of the most respected general emerging market funds also have big weightings to Taiwan and South Korea, and these are a good bet if you're keen on getting exposure to these countries as they're less risky than single-country funds.
First State Asia Pacific Leaders (ISIN: GB0033874214) is the leader of the pack. With 10.84 per cent allocation to Taiwan and 9.72 per cent in South Korea, it is a first-quartile performer over one and three years, returning 18.7 per cent and 45 per cent, respectively. And First State Global Emerging Market Leaders (ISIN: GB0033873919), one of the funds selected in our Top 100 Funds list, has returned 16 per cent over one year, (it has 11.5 per cent in Taiwan and 7.6 per cent in South Korea), while Aberdeen Asia Pacific (ISIN: LU0837964567), which has 5.2 per cent in South Korea and 5.1 per cent in Taiwan, managed 13 per cent over a year, but is only a fourth-quartile performer in the Asia Pacific ex Japan sector.
So getting exposure to these economies probably isn't going to do your portfolio that much harm, but if you believe the developed world is in decline and young, thrusting emerging economies will overtake the developed economies, you might want to reconsider having these funds in your portfolio.
