Investment: After the bloodbath

THE STANDARD academic response to a troubling piece of data is to say: "That's all very well in practice, but how does it work in theory?" The problem with emerging markets, whose rise to respectability in the past few years is largely the result of academic endorsement, presents the opposite problem. The theory behind investing in emerging markets is sound and forceful. But making it work seems to be harder than many professionals expected.

The case for putting part of a substantial investment portfolio into emerging markets is based on the argument that the markets should produce higher returns over the longer term despite inevitably higher levels of volatility. Their low historic correlation with Wall Street and other mature stock markets also suggests they should provide significant diversification benefits for investors in developed countries.

Two problems emerge. One is that the facts about volatility and performance are not as robust as original data suggested. This was demonstrated last year in the wake of the East Asian and Russian crises and the subsequent investor panic, which led to a "flight to quality" around the world.

The problems in Asia were a powerful reminder that although many emerging markets have experienced higher rates of growth for years, there is nothing inevitable about their rates of expansion. More worrying was that all world markets suffered because of the crisis in confidence, and emerging markets suffered more as investors ran from perceived risk.

Although the long-run correlation between developed and emerging markets looks robust, last year suggests the diversification benefits may not be as powerful as academics argued. With increasingly global markets, you would expect the correlation between all financial markets to increase, so historical data may not give a true picture of current reality.

One further problem is highlighted in the latest Standard & Poor's Fund Research survey of emerging market fund performance. Unless you are brave enough to think you can pick individual countries, the only way to gain exposure to emerging markets without excessive risk is to buy a diversified regional or global emerging market fund. It isn't possible for ordinary investors to make the country allocation decisions or to buy the stocks themselves.

Here is the bad news. The majority of emerging market funds find the job almost as difficult. In the 12 months to 1 May 1999 covered by the survey, the 247 emerging market funds monitored underperformed the main emerging market index by a substantial margin. The average fund lost 17 per cent in the year to 1 May 1999, more than twice the figure for the relevant composite index. More remarkably, there was a huge disparity in fund performance, the difference between the best and worst being more than 100 percentage points.

Over three years, seven out of the 247 funds had a positive return of more than 10 per cent. Most funds show losses on a five-year view. Over 10 years, not even the best-performing region (Latin America) has come near matching the performance of Wall Street.

One irony is that many cautious fund managers who built up cash reserves last year were badly burnt when the emerging markets started to rebound. Fund Research says: "The past 12 months have been extraordinary, some fund managers struggling to fit long-held philosophies to the reality of markets. Cash has been used more freely as a defensive weapon to minimise the collapse in share prices, typically up to a maximum of 30 per cent of portfolios. Most managers have lost by this strategy as markets turned around so quickly. They are unlikely to use cash as actively again."

Some of the best emerging market specialists caught last year have struggled to catch up from less than fully invested positions and having portfolios full of defensive stocks. This demonstrates why active fund managers often fail to outperform index funds even in falling markets where they ought to have an advantage; psychology stops them investing more when markets are in periodic crisis. This year has been exceptionally good for emerging markets. Many have huge gains. Mexico and Korea have done particularly well, as has Russia, if you believe the figures and can bear the thought of investing in such an unpromising place, which I cannot. In theory, anyone who could pick the right countries to invest in each year would have a fortune in 10 years. The truth is that it is next to impossible to time your way in and out of countries with consistency.

Not many emerging market investments secure high ratings from Fund Research. The three best are Capital International, Morgan Stanley and The Franklin/Templeton Group. All put heavy emphasis on bottom-up research into companies. The flagship funds of these groups have outperformed the relevant indices consistently over five years.

Mark Mobius, Templeton's emerging market guru, is among the disciplined long-term value investors with the courage to buy shares when markets are at their gloomiest and have the best chance of a consistent track record. Those who took my advice to buy into Templeton Emerging Markets Investment Trust last year have no regrets. The price is up 94 per cent over 12 months.

Davisbiz@aol.com

Comments