Despite the doom and gloom currently surrounding emerging markets, the long-term outlook remains favourable. Rayner Spencer Mills' Ken Rayner considers some fund picks.
The IMA Global Emerging Markets sector comprises funds which invest 80% or more of their assets in emerging market equities as defined by the relevant FTSE or MSCI Global Emerging Markets index. When considering this area, we also selectively include funds in the IMA Specialist sector that focus on regions within the emerging markets universe.
Global emerging market funds offer the potential for investors to achieve above average growth, albeit with the likelihood of higher volatility. At present, emerging markets account for 37% of world GDP but only 13% of the MSCI World index.
However, their importance in global equity weightings is set to increase significantly over the next decade and we believe this area will become an increasing part of investors’ allocations.
Emerging markets: Why the long-term forecast has a silver lining
The region has been negatively affected by exchange rate appreciation, as well as by the deterioration of the return on equity. In 2009-2010, return on earnings in the emerging world had been ahead of developed markets; however, this is no longer the case and the decline in markets has brought the price to book ratio for the region back to 1.5x versus an average of 1.8x to 1.9x. Emerging markets now, once again, stand at a significant discount to the developed world.
In the short term, problems have been exacerbated by twin current account and fiscal deficits in certain countries – flows to many emerging markets have become negative and currencies have taken a dip, creating a vicious circle.
Despite the short-term doom and gloom, the long-term favourable structural outlook for the region remains intact. Demographics are broadly positive, with some relaxation expected shortly on the one child policy in China, and there remains scope for productivity gains in the emerging world to underpin economic growth.
Medium-term headwinds have now resulted in a significant deterioration in sentiment towards the emerging world. While structural growth potential remains, the key short term risk for the region is its vulnerability to capital flows, especially in countries with twin deficits.
Valuations have now come back to attractive levels but the environment for the asset class is likely to remain choppy in the short term.
Brazil accounts for 60% to 70% of the Latin American index and has suffered due to its twin deficits with a significant fall in its currency. There have also been popular protests in Brazil against the rise in the cost of living, particularly in essentials. Inflation has increased and interest rates have been raised.
The government’s supposedly populist policies have not helped and there has been regulatory intervention in Brazil in sectors such as power, utilities and banking.
The Mexican economy looks better, with some structural reform and close links to the recovering US economy. Both Chile and Peru have seen a slowdown due to their reliance on commodities, particularly copper.
Elsewhere, the Central Eastern European markets have performed well on the stabilisation of the eurozone. Russia has held up due to its budget surplus. The country is not reliant on external capital and a high oil price (anything over $90) has been a positive. More stocks have been announcing dividend increases.
Core fund picks
When it comes to fund selection, the range of choice has been reduced, with two of the leading vehicles in the region now soft-closed. Both Aberdeen’s and First State’s well supported core emerging markets funds are now unavailable. There are, however, alternatives. The core funds that we would consider in this area would include:
JPMorgan Emerging Markets: This fund has a team process, which results in a diversified portfolio with a quality bias.
Lazard Emerging Markets: This fund operates a bottom-up team approach with a detailed stock screening and macro overlay. This is a more cautious fund style and will lag market rallies.
Satellite fund picks
Meanwhile, our satellite holdings would include:
Fidelity Institutional Emerging Markets: This fund focuses on high quality growth stocks with high return on earnings and low debt to equity businesses. It uses a bottom-up approach with high active weights.
M&G Global Emerging Markets: This fund, managed by members of the global team, has an emphasis on shareholder value creation and a HOLT based valuation metric utilising CFROI. The fund is multi-cap in nature, with value orientation.
Templeton Emerging Markets Smaller Companies: This fund invests in the smallest companies and, therefore, provides diversification to mainstream funds. The fund takes a value orientated approach, only investing in modestly rated companies with strong growth prospects, and focuses on domestic consumption.
Mix and match
The starting point for fund selection is to look at the core funds, which provide a strong combination due to their different investment approaches. The use of core funds in this sector is more likely to form the primary holding for most portfolios in the balanced risk area, with the addition of satellite funds more likely to make sense in larger or higher risk portfolios.
For investors who want to add a value orientated philosophy, the M&G fund is a useful addition to a portfolio and can be used effectively with all the core funds. The Templeton fund offers another level of diversification to the core funds by focusing on smaller companies. The very little commonality at stock level means this vehicle can be used with all the core funds.
(IMA) Global Emerging Markets
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