Emerging markets can be a whole new world

Bright young things, from India and China to Bulgaria and Botswana, offer risk and reward and help investors diversify. Sam Shaw reports

Wine enthusiasts often refer to the 'old' and the 'new' world – the old world being steeped in heritage and stability while the bright young things represent modernity and risk-taking. It's all just a matter of taste.

The same thing is true of investment risk – a greater thirst for risk can still be sated by the newer parts of the investment world, except here they are often referred to as the 'emerging markets', with the old world comparable to 'developed markets'.

While the most basic of investment theory is rooted in the idea that a greater risk can often lead to greater rewards, life is rarely that simple. But while specialists like Barings' Head of product and business development David Stephenson highlight the volatility that investors face when they enter these markets, they suggest that investors simply can't achieve decent investment diversification – a critical consideration for a robust portfolio – through large-cap, developed market equities any more. Can investors pick their way through the minefield of opportunities? Or should they be concerned by evidence of a change in fortune after the US stops printing money?

'Emerging markets' is something of an umbrella term; these are countries with social or economic activity in a growth phase. Think China, India, Brazil and Russia, the top four. Investors can access emerging markets in several ways. One of the most popular choices is to invest in a generalist 'global emerging market' fund. In fact the popularity of these funds has seen two of the larger offerings – from Aberdeen Asset Management and First State – recently announce closure to new investments, having already reached full capacity. Elsewhere, investors can go for regional or single-country funds.

When it comes to single-country funds, Stephenson also encourages handing over to the experts. “You might be taking an undiluted single-country risk, but you tend to be rewarded with undiluted single-country returns. The manager would generally have a long-standing, deep understanding of that country, know when to move into cash, could identify the showstoppers and have a familiarity-style bias.” But he warns these can bring higher trading costs such as taxes, stockbroker commissions and fees, an impact of the price the stock is bought at versus that at which it is sold (known as the bid-offer spread) and borrowing costs.

Lee Robertson, chief executive at London-based wealth management boutique Investment Quorum, says for most of his clients, generalist funds suffice. He prefers to access to single country exposure on a very tactical basis using exchange-traded funds, for their greater liquidity and cheaper entry.

It's little surprise that emerging markets have grabbed the attention of investors around the world. In the last 15 years, emerging market equities have risen a phenomenal 370 per cent compared with their global peers, which have risen 80 per cent.

But more recently fortunes have reversed and things are getting worse. While the MSCI World Index has risen 44.5 per cent, including a 5.5 per cent boost in the last six weeks, MSCI Emerging Markets has remained flat, at just over 2 per cent, dropping nearly 11 per cent in the same 6 week period.

Ben Yearsley, head of investment research at Charles Stanley Direct thinks the markets are painting a confusing message and suggests a buying opportunity is on the cards.

“Emerging markets were the hot ticket for some time, and now, people seem to be getting scared because they think Quantitative Easing (QE) is ending. But then the US market has gone up pretty strongly, it's all slightly contradictory this year.”

In other words, when the US's money taps were turned on full, investors wanted somewhere to spend it all. They sought higher rewards and flocked towards the emerging markets. Now that QE is winding down, the reverse is expected – with that money returning to domestic shores.

Fidelity's asset allocation director Trevor Greetham also cites the reversal of QE by the Fed as fuelling their decline and the recovery in the US, expecting interest rate rises and further capital hitting markets. He said this process was already well underway and believes it could last years. “The massive money printing by the Fed was invested in emerging market shares, in building projects and was all keeping inflation, and their currencies, in check,” he added.

As capital flows out of emerging markets and returns to the US, Greetham believes it would probably strengthen the dollar. A stronger dollar tends to drive down commodity prices, further adding to the woes of these emerging economies.

These fears have hit currencies across the regions hard, with a number of emerging market currencies tumbling rapidly against the dollar recently – led by the Indian rupee's continued downward spiral.

So with India in a state of political gridlock, Brazil at pretty flat growth and Russia beset with political problems, is it all doom and gloom?

Yearsley finds a silver lining: “I think the problem is that people tend to forget the positives and only remember the negatives. Russia is trading on 5x earnings and yielding 4 per cent, which is a decent return by anyone's standards.”

China's problems appear to be here to stay though, which means that unless an investor has a very long-term horizon, emerging markets might not be suitable.

“A 10-year view is sensible,” suggests Holland. “It wasn't that long ago that people were paying more for emerging market equities because the GDP figures suggested it was worth it. Now that is slowing, emerging market equities are trading at a discount. The reverse has happened.”

Jason Hollands, managing director at Bestinvest, says he has become more cautious on emerging markets based on concerns over China but agrees that newcomers to the sector could build a position quite cheaply, providing they have the nerve to ride out the volatility expected over the coming years.

Then there are less developed 'frontier' markets, where Stephenson suggests anything up to a 20-year investment horizon might be more appropriate, depending on the nature of the investments.

“Countries like Botswana, Bulgaria, Sri Lanka and Vietnam would probably best be accessed through a frontier markets fund. If I was looking for growth over 10 or 20 years, I'd certainly consider one. I just wouldn't be looking at my investments every day as I'd be scared about the extreme movements.”

With the right time-frame and risk appetite, frontier markets may suit those wishing to avoid the close relationship larger economies have with commodity markets but which still offer broad diversification, according to Hollands.

Commodities are the driving forces behind many emerging market countries' fate – either through imports, as is the case with China, or through exports, as in Russia, or Brazil. The extremes of performance of this asset class mean liquidity – the ability to withdraw your money – is a crucial factor.

But if all that sounds a bit scary, don't forget that many companies listed on UK and European stock markets are heavily exposed to growth in China and other emerging markets. So you may find your investments are already facing the emerging world far more than you realised. And they might be a less punchy way to quench your thirst.