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Back to basics: how to invest in emerging markets

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Written by: Darius McDermott
11/05/2016
Why a carefully selected active fund is the best way of accessing the opportunities in emerging markets.

When it comes to picking travel destinations, many of us have no problems getting ‘adventurous’. India, Brazil and Thailand are among the most popular tourist spots in the world.

When it comes to choosing investments, however, we’re more likely to go with the equities equivalent of a long weekend in Dorset – something like a UK All Companies or UK Equity Income fund, perhaps.

There’s nothing wrong with investing domestically (or holidaying in Dorset, for that matter). But you know what they say, variety is the spice of life. UK funds may always be the cornerstone of your portfolio; however, adding in some of these ’emerging markets’ could give your returns a sizeable boost over the years.

The trouble is how to go about it, especially if you like to keep things in your portfolio ‘simple’. To continue with the analogy, selecting UK equities or funds is akin to booking a quaint British countryside bed and breakfast. You do some research and compare prices, but ultimately you have a fairly decent idea of what you’re getting.

If you’re trying to book a bungalow in Kerala in southern India, the risk is far higher you’ll get rather more (or less!) than you bargained for. Likewise, when you buy equities in developing countries, you’re effectively taking on a number of extra risks such as potentially less stable politics, less corporate transparency, more government interference in markets and more volatile currencies.

Of course, the trade-off is that emerging market economies can grow much faster than the average developed country. Young populations, rapidly expanding consumption and significant infrastructure spending all help boost share markets. When you’re thinking about investing, these are the benefits you want exposure to.

What you don’t want are the large numbers of state-owned enterprises or big family-run businesses, many of which have a history of questionable corporate governance and of not acting in the best interests of their minority shareholders. The size of some of these businesses (think Petrobas in Brazil) means they often comprise significant portions of emerging market indices.

China’s many state-run banks are another good example, with poor lending practices resulting in debt pile-ups that render the entire sector risky. Future growth in China is predicted to come from its ‘new world’ companies in industries such as consumer services and healthcare, but these changes are yet to be meaningfully reflected in its stock market sector weightings.

This is one reason why passive funds, which simply replicate the indices, are not such a good bet in emerging markets, in my view. Most of your money ends up being invested in larger, older companies. You also have to watch out for ‘closet trackers’ among emerging markets funds, which purport to be actively managed yet still stick closely to the index.  After all, why would you want to invest in yesterday’s winners?

Instead, I like to recommend funds in this space that ignore the index almost entirely. The best managers start with a ‘blank page’, seeking out opportunities according to a strict set of quality criteria, as opposed to mirroring a benchmark. They are looking for tomorrow’s success stories.

I particularly like FundCalibre’s Elite Rated M&G Global Emerging Markets. Manager Matthew Vaight has a real focus on finding companies with a strong corporate culture and more than 50% of the fund is invested in small and medium sized companies.

Another fund that has a good global range is the Elite Rated Lazard Emerging Markets, whose manager, James Donald, has been working in emerging markets for more than 30 years. He is aided by a team of analysts worldwide who pay particular attention to political situations.

In terms of investing style, both of these managers focus on finding ‘value’, meaning they look for cheap companies they believe have strong recovery potential. This style has been a bit out of favour over the past couple of years, but value investing has historically outperformed over the long term. What it does mean is that you may find ‘unloved’ companies in struggling sectors within these funds’ holdings. It is a case of trusting disciplined managers to make investments they believe will deliver superior returns for their shareholders.

If you want to get more concentrated in terms of a particular country or region, we also recommend a few funds such as the Elite Rated Goldman Sachs India Equity Portfolio and Matthews Asia Pacific Tiger fund.

Whichever way you go, do remember that emerging markets should be for the long term and, due to the nature of the risks we spoke about earlier, the value of your investments may rise and fall much more dramatically than a UK equity holding. You can’t expect to see positive returns every year, but the idea is that the returns in the good years will make the bad worthwhile.

Who knows, maybe investing in an emerging market fund today will help you to pay for your next big trip – wherever you choose to go.

(All fund data correct at 31/3/16)

Darius McDermott is managing director of fund ratings agency FundCalibre

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