Advisers often tell their clients to invest in what they know, leading many to allocate their funds primarily to domestic, familiar markets. However, the performance of emerging markets often differs greatly from that of developed markets, helping to create a broadly spread portfolio.
Emerging markets are classified by the World Bank as a country with low-to-middle per capita income. For the current 2015 fiscal year, the World Bank defines low-income economies as those with a gross national income (GNI) per capita of $1,045 or less in 2013, and middle income to be those with a GNI per capita of more than $1,045 but less than $12,746. Countries under this classification include China, India, the Philippines, and Latin American countries.
The funds that make emerging markets their investment objective may be regionally specific – such as Latin American or Asia Pacific excluding Japan – or can encompass all types of emerging market countries into one.
Unit trusts
The best way to access emerging markets is probably through a unit trust or an investment trust. Table 1 looks at the top performing emerging market funds and investment trusts.
Templeton’s Emerging Markets Smaller Companies fund takes top spot as the best performing unit trust as of 1 February. Launched in 2007, the £224m fund charges an entry fee of 5.75 per cent and an ongoing charge of 2.5 per cent
Equity securities issued by smaller companies, typically valued at around $2bn USD in market capitalisation, are the focus of this fund. These companies must be located in, or do significant business in, emerging markets.
The fund also broadens its scope to include, albeit to a lesser extent, equity and equity-related securities, such as participatory notes, issued by companies of any size located in any country. Debt securities of any quality, including lower quality debt such as non-investment grade securities, issued by companies and governments in any country, are also on the radar of Templeton’s investment managers.
Investment trusts
Investments trusts can be a better vehicle for emerging markets than unit trusts. If shareholders feel nervous about the market and sell their shares in the trust, investment trusts can still hold on to their investments. Unit trusts, on the other hand, may be forced to sell some of their holdings in this scenario in order to pay exiting investors.
BlackRock Frontiers, launched in 2010, is the best performing investment trust. The £174m fund, managed by Sam Vecht and Emily Fletcher, charges an annual management fee of 1.1 per cent of total assets, an ongoing charge of 1.45 per cent, and a performance fee of 10 per cent of any net asset value (NAV) outperformance of the MSCI Frontier Markets Index.
The Frontiers fund invests primarily in equities with some cash alternatives and derivatives. Kuwait, Pakistan and Bangladesh are the largest regional focuses of this fund, with some allocation also given to Sri Lanka, Romania, Kazakhstan, Morocco, Argentina and Ukraine.
Companies in the finance sector comprise 29.9 per cent of the fund, with energy, consumer staples and telecommunications taking a significant portion of investment. Kuwait Food Co and the Kuwait-based Mobile Telecommunications Co share the position of largest percentage of assets in the fund’s holdings with both at 4.8 per cent.
Market performance
One way to track the general performance of the emerging markets sector as a whole is through the MSCI Emerging Markets index, which demonstrates large and mid-cap representation across 23 emerging markets countries.
This index covers approximately 95 per cent of the free-float adjusted market capitalisation in each country.
It should be remembered that the index includes an array of countries. Monitoring the index demonstrates the need for investors to see emerging markets as a long-term commitment. The annual performance for the MSCI Emerging Markets Index in 2014 was down 2.19 per cent, with the index performance net returns at 0.6 per cent for one month to 30 January 2015 and down 5.1 per cent in the three months to that date. However, the annualised net return since the index’s inception in December 2010 is 10.4 per cent.
Emerging markets tend to be sensitive to fluctuations in developed markets. In 2008, during the financial crisis, the MSCI Emerging Markets Index lost 53.3 per cent of its value, yet rebounded by 78.5 per cent the following year.
The recent fluctuation in oil prices has also had a mixed impact on emerging markets depending on whether they are net importers, like China, or exporters, such as Venezuela. Advisers should not shy away from recommending emerging market funds in their client’s portfolio as a way to diversify their investments, so long as they have a long-term outlook.
Emerging markets may fluctuate in the short-term, but deliver returns in the long-term.
Five questions to ask:
1. Who are emerging markets funds right for?
Emerging market funds are best for investors looking to add diversity to their portfolio, especially if they already have a high allocation in developed markets. Investors should also not have an adversity to short-term risk and be prepared for a long-term investment.
2. What are the routes into emerging markets?
Access to emerging markets is available directly or through unit trusts and investment trusts, as well as through exchange traded products that track an market or benchmark.
3. Active or passive?
Active management allows managers to adjust the portfolio based on developments, but it is difficult to predict activity and it does pose the risk of country discrimination. Passive funds do not rely on managers to beat the market, and instead follow its movements organically.
4. What is the ideal timeframe?
Emerging markets investment should be undertaken with a long-term view. These markets undergo more short-term fluctuation than developed markets but offer greater opportunities for growth over the long-term.
5. What risks are involved?
Risks that arise stem from investing in countries that have less developed political, economic, legal and regulatory systems. They are more likely to be impacted by political or economic instability, lack of liquidity and transparency.
