What are emerging markets and should I risk my money in them?

In the first of a series, Alison Eadie examines the arguments for investing in the developing world
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The Independent Online
The fizz has returned to emerging markets. After two years of underperformance against developed markets they are roaring away again. The Russian stock market has doubled in value in dollar terms from the start of this year. Other stars include Brazil, up 31 per cent, Venezuela, 29 per cent, India, 31 per cent, the Philippines, 23 per cent, Hungary, 88 per cent and Poland, 57 per cent.

Despite the bounce, experts insist there is plenty of value still to be had across the globe. The slump in stock markets last year was largely a correction to the froth of the previous two years. The rise in US interest rates in early 1994 and the Mexican debt crisis of January 1995 stopped the party, but economic growth, which provides the rationale for investing in such volatile markets, marched on as before and should continue to do so. The International Monetary Fund has forecast emerging countries will have annual growth more than double that of developing countries over the next three years.

So is now a good time to pile in? The UK market is at historically high levels and a general election is looming. But are emerging markets only for high-net-worth, adventurous investors? The experts say no.

A strong stomach is essential, as these markets can be roller coasters, and so are long time horizons. Money should be tucked away for a minimum of five years, preferably 10 or 15. Over time analysts expect emerging markets to grow at a compound 15 per cent a year compared with 10 per cent for developed markets. Recently they have managed 19 per cent compound growth, but this is expected to slow.

Developing economies grow faster because they start from a lower technological base and gain huge strides from improved life expectancy and literacy. They represent some 10 per cent of the world's stock markets by capitalisation, so 10 per cent is often suggested as a reasonable allocation of an individual's assets. But this is no magic number.

There is also a large and growing choice of markets. Defined by the World Bank as countries with low to middle income per head, some 85 per cent of the world's population lives in emerging countries, which include most of Asia, all of Africa, Latin America, Eastern Europe and parts of Southern Europe and the Middle East. There are more than 100 emerging countries, although fewer than half are open to foreign investment.

Templeton Emerging Markets Investment Trust (TEMIT) invested in just six countries when it launched in 1989. It now researches more than 40 countries and invests in 25. As economies grow richer they cease to match the World Bank definition. Hong Kong and Singapore have moved on, although they still feature in many emerging markets portfolios. Taiwan, South Korea, Malaysia and Thailand may exit next. Others are waiting in the wings to take their place. Stock markets open to foreign investors are promised in Vietnam, Cambodia and Myanmar (Burma).

However, the name of the game is no longer spotting the new market and getting in first, according to Jan Kingzett, a director of Schroder Investment Management. "The game is now to find a good manager who can squeeze performance out of the stocks," he says. He points out that emerging markets have become an accepted part of portfolios and are subject to the same investment disciplines and performance criteria as developed markets.

Managers should be chosen for their track record and funds - global, regional or single country - according to the investor's appetite for risk. The more diversified the fund the less risk. Single country funds can offer spectacular returns but are only for the brave.

Investment strategies vary between fund managers. Templeton has an impressive record achieved through a bottom-up or stock-picking approach. TEMIT does not try to beat an index or invest according to regional or country allocations, but seeks cheap shares wherever they can be found.

Foreign &Colonial Emerging Markets Investment Trust, by contrast, adopts a top-down approach. Its benchmark is the Global Composite Index from which it deviates - over or under-weights countries - according to the findings of its research. Having fixed a country allocation it then adopts a stock-picking approach. Arnab Banerji, chief investment officer at F&C Emerging Markets, explains: "There is much to be said for the bottom-up method. But you could have bought the best stocks in Mexico and still lost heavily. You need a country view."

Research from UBS backs him up. It concludes, after analysing 11 years of data, that "the choice of country is the most important tactical allocation decision for a global or regional emerging markets fund. Sector and stock picks are and should be subsidiary."

Tracker funds, which match the performance of stock market indices rather than trying to beat them, offer an alternative. However, as emerging markets are rapidly moving targets, this approach has inherent contradictions. John Legat, of LGT Asset Management, points out: "The bigger economies with bigger stock markets are the largest constituents of emerging markets indices. But they are the more developed countries and we are supposed to be investing in developing countries, so it becomes a bit of a nonsense."

A variation on a tracker theme is offered by City of London's Emerging Markets Country Investment Trust. It invests in closed-end funds, which sell at an average 20 per cent discount to their respective stock market indices. Some 75 per cent of its funds are trackers. Barry Olliff, the fund manager, says 75 per cent of the outperformance achieved by the trust is due to buying cheaply and 25 per cent to asset allocation. He says the Country Trust is low risk relative to other emerging markets funds because of its diversification. It holds around 3,600 stocks through investing in 60 funds.

Whatever the investment philosophy, a good manager is supposed to squeeze more out of emerging markets over time than a manager of UK equities. According to Micropal, the funds analyst, TEMIT has turned pounds 100 into pounds 312 over the five years to June, but pounds 100 in Gartmore Emerging Markets unit trust over the same period would have grown to just pounds 135, beaten handsomely by the lower-risk UK stock market.

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