Why do emerging market funds invest in developed market shares?
Beginner investors looking at emerging markets may be surprised to see developed market stocks within the funds. Here’s a quick explainer.
If you’re looking to invest in the likes of China, India or Brazil, you could find the fund invests in developed market stocks from say the US or the UK.
The Investment Association confirms that funds in emerging market sectors are able to invest in developed markets as its sector definition requires 80% of assets to be invested in emerging market equities.
That therefore leaves a potential 20% allocation to satellite assets – those that aren’t core, so some allocation to developed markets is standard.
As an example, the IA Global Emerging Markets sector is defined as ‘Funds which invest 80% or more of their assets in equities from emerging market countries as defined by the relevant FTSE or MSCI Emerging Markets and Frontier indices. The maximum frontier equity exposure is restricted to 20% of the total fund’.
Meanwhile, the Association of Investment Companies, the trade body for the investment trust industry, has a sector definition for Global Emerging Markets with the following characteristics to make it easier for investors to compare like for like:
- Over 80% invested in quoted global emerging market shares
- Less than 80% in any single geographic area
- Investment objective/policy to invest in global emerging market shares
- Global emerging benchmark
These are the characteristics which the AIC’s independent statistics committee considers when they allocate companies to the appropriate sector. However, these are guidelines only.
‘Emerging market exposure but lower risk’
Darius McDermott, managing director of Chelsea Financial Services and FundCalibre, explains that some EM funds use this allowance to buy companies that are listed in DMs, but have large exposures to, or most of their revenue from, EMs.
He says: “This way, they continue to get the benefits of the fast-growing emerging market regions, but the benefits of developed market stock markets too – such as corporate governance, good shareholder bases and better functioning capital markets. In other words, emerging market exposure but often with lower risk.”
McDermott adds that this isn’t seen a lot, though it isn’t “that unusual” to see one or two DM listed stocks in an EM fund.
“For example, GQG Partners Emerging Markets Equity fund has both Exxon Mobile and Heineken in its top ten. The classic example is Unilever, which gets the majority of its business from emerging markets despite being listed in London.”
‘Local presence gives the company an edge’
Indeed, Chetan Sehgal, lead portfolio manager of Templeton Emerging Markets Investment Trust, (TEMIT) holds Unilever in the UK, as well as two US IT services companies.
He says: “Our holdings in the US are Cognizant and Genpact. These businesses were founded with Indian roots but later listed in the US. Even today a majority of their employees are based in India and for Genpact the majority of revenue is attributed to the Indian subsidiary.
“It is not uncommon for EM companies to list on DM stock exchanges, and we would view these as an extension of our investment in Indian companies. They are attractively valued and provide exposure to the booming IT services and business process outsourcing industries in which India is a world leader.”
And turning to Unilever, a multinational food and household products company which derives the majority of its revenue from emerging markets, Sehgal says: “These have also been the driver of revenue growth for the company over the past several years.
“The company has more than 50 years of experience in India, Brazil, China and Indonesia and it has identified India and China as amongst its three strategic markets for growth. A local presence in many countries gives the company an edge in dealing with distribution structures in emerging markets and in customising product offerings to local demand. The next billion consumers of Unilever products will predominantly hail from emerging and frontier markets.”
As of end-July, TEMIT held 1.7% in the UK and 3.8% in the US.