Look beyond China for opportunities in emerging markets

Emerging markets have long been an imperfect grouping for countries with very different economic growth patterns, levels of technical advancement and industrial development. For example, while China leads the world in areas such as social media and renewable energy, Russia is still dependent on oil and gas. And Brazil’s wayward politics look very different to the stability of India. So in emerging markets, country and regional allocation matters.

This has been particularly true since the start of the pandemic. China was the top performing of all major markets in 2020, with MSCI China index up 26 per cent over that 12-month period. MSCI India turned in a creditable performance with a 17 per cent increase in 2020, but it was a dismal year for MSCI Russia which fell 3 per cent, MSCI Brazil which only rose 2 per cent and MSCI Indonesia which was down 9 per cent. These markets were struggling to overcome the multi-faceted impact of the pandemic.

However, this direction of travel wasn’t new. China has outpaced its emerging market rivals for the past five years and its internet giants have grown as powerful as their US equivalents. It has left a situation where many global emerging market funds and the indices in which they invest are more focused on Asian-listed companies with a sprinkling of ones listed on other emerging markets – rather than a broader representation of markets across these regions.

At the end of September, about three-quarters of MSCI Emerging Markets index's capitalisation was made up of Asian giants China, Taiwan, South Korea and India. Brazil, the next largest weighting, accounted for just 4.5 per cent. So this index now has considerable overlap with MSCI Asia Pacific index. Six of these indices' 10 largest constituents are the same and, apart from MSCI Asia Pacific's 14 per cent weighting to Australia, these two indices' country weightings are also remarkably similar.

As a result, their performance has been close. Over three years to 30 September, MSCI Emerging Markets has delivered an average annualised return of 8.6 per cent and MSCI Asia Pacific has delivered 9.45 per cent, according to MSCI. And where MSCI Emerging Markets index has led, many active fund managers have followed, so that the top-performing emerging market funds almost all have high weightings to China and its internet giants such as Tencent (HK:700) and Alibaba (HK:9988).

In recent years, this Asian dominance hasn’t mattered very much. China has been the sweet spot in emerging markets and its technology companies have gone from strength to strength, leading the world in areas such as social media. However, the world is changing.

Recent actions by Chinese policymakers have forced emerging markets investors to reappraise their weightings to China. Louis Tambe, senior investment analyst at City Asset Management, says: “This started 12 to 18 months ago as the Chinese Communist Party took action against Jack Ma and Ant Financial. It prompted many fund managers to look again at their China weighting. More regulation has followed, including data disclosure rules for Alibaba and gaming limits for Tencent. These companies may now be in a consolidation phase with much lower profits.”

If anything, the internet sector escaped lightly. The recent crackdown has wiped out certain industries, such as online tuition, and been an abrupt reminder that China will only tolerate capitalism to the extent that it doesn’t interfere with its social goals.

Opportunities elsewhere

At the same time, there are shifts in other emerging markets. A possible change in direction by the US Federal Reserve is shifting the outlook for some emerging markets, while many of the commodity-producing emerging market countries are benefiting from the global economic recovery. The problem has been that many emerging market investors haven’t benefited because their funds aren’t invested there.

The dominance of China also means that emerging market investors may be overlooking opportunities elsewhere. Juan Torrez Rodriguez, co-manager of Schroder ISF Emerging Markets Value Fund (LU2180924461), says: "We strongly believe that, within the emerging markets universe, there are many different countries and even regions that have been overlooked over the past decade and are offering incredibly good opportunities going forward. People investing in emerging markets tend to be overly focused on two specific countries and, within those two specific countries, one specific sector: Chinese technology. Those are very good companies, but other good opportunities have been overlooked.”

Vera German, co-manager of Schroder ISF Emerging Markets Value, believes that investors can find companies displaying strong growth at extremely cheap valuations. She adds: “Over the course of the past year, partly driven by the uncertainty that came with Covid-19, we were able to find very attractive companies in South Africa, for example.”

The challenge for investors is to ensure that their emerging market exposure is balanced and not entirely dominated by the fortunes of China. This isn’t easy, but genuinely active managers at least have the flexibility to rotate away from problem areas into areas likely to show strong growth.

Kelly Prior, investment manager in the multi-manager team at BMO Global Asset Management, says: “We very much prefer to leave the geographic allocations to the managers [of the funds we invest in] and in emerging markets probably more than any other area. The opportunity set is as varied there as any region, more so now than ever given the impact of Covid-19 and individual countries’ experiences. There is most definitely a core of managers in the sector that reference the benchmark at the country level. However, I think it is fair to say that there are also a decent slug of offerings where managers take big bets at the individual security level without feeling the need to keep their country allocations in line with the benchmark – [one of our recent purchases] Schroder Emerging Markets Value being one such fund.”

Giampaolo Isolani, head of emerging markets investment solutions and market intelligence at Amundi Asset Management, shows how this can work in practice. He had already rotated away from large-cap Chinese names before the government’s regulatory clampdown took hold.

 “We moved into Chinese smaller companies which are up 20 per cent for the year to date," he explains. "At the same time, we saw that commodity prices were rising, so started to look at Russia and Brazil. Brazil is still struggling with high government spending and political instability, but valuations looked good for Russia and there is leverage on commodity prices.”

He adds that India, by contrast, looks vulnerable to higher energy prices and valuations in that market look high after a strong recent run.

Finding a fund to diversify

In this new environment investors need to be brave and hunt among funds where performance may not have looked sparkling in recent years. The difference between the top- and bottom-performing funds in 2020 was 78 per cent, and almost all of the top performers were overweight the major internet names. That leaves you looking for a fund that has done reasonably well from non-China and non-technology names. Finding one that meets these specifications isn’t easy, but Tambe suggests that GQG Partners Emerging Markets Equity (IE00BDGV0K75) has done it successfully.

The other option is for investors to separate China and emerging markets. While there are plenty of China funds, the problem is that emerging markets ex-China funds don’t exist. The closest would be a fund such as BlackRock Frontiers Investment Trust (BRFI), which excludes the eight largest emerging markets (see table0, or Jupiter Emerging & Frontier Income Trust (JEFI), which had 16.7 per cent of its assets in China at the end of September.

If you want to rebalance your emerging markets exposure, another option may be regional funds focused on certain areas of other emerging markets. Aberdeen Latin American Income Fund (ALAI), for example, had a yield of over 7 per cent at the end of October and traded on an 11.5 per cent discount to its net asset value (NAV).

Barings Emerging EMEA Opportunities (BEMO) invests across emerging Europe, the Middle East and Africa. It has recently had a strong run of performance, but was still trading on a 10.6 per cent discount to NAV at the end of October.

So where does this leave stockpicking? Isolani says there will always be companies that can transcend weakness in their economy. “Exporters, for example, can be in a strong position even when the domestic economy is weak,” he explains.

But he still believes that ultimately it is difficult to be a ‘pure’ stockpicker in emerging markets and Amundi’s analysis always takes into account both macroeconomic and company fundamental factors.

Asset allocation can be a key determinant of returns in emerging markets, so you need to ensure that you know what you’re getting – particularly if you hold emerging markets alongside Asia-focused funds. The outlook may be changing for China at the same time as opportunities are emerging elsewhere.