Emerging Markets  

Passive investors return to space as resurgence persists

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The Guide: Investing in emerging market equities

Passive investors return to space as resurgence persists

Emerging market equities, alongside Europe and Japan, were one of asset allocators’ favoured regions at the start of this year. But retail fund flows have remained lacklustre since that point, despite signs of a resurgence for developing markets.

The asset class was tipped for a comeback in 2017, and so far equity markets have not disappointed. The MSCI Emerging Markets benchmark has been the best-performing major index year to date, returning 25 per cent in local currency terms. The next closest is Europe, which has gained 13 per cent.

Despite this sustained recovery, fund buyers remain cautious. Figures from the Investment Association show that year-to-date net fund flows stand at only £335m regardless of the outperformance. In comparison, the Europe ex UK sector has pulled in £895m and Japan £751m. 

As these two figures imply, equities are having a relatively good year, so risk sentiment is not the issue.

The space’s popularity among passive investors is growing, however, suggesting that institutional investors are returning to the space. 

European ETFs investing in emerging market equities have attracted €5bn (£4.4bn) this year, with only US corporate debt strategies posting stronger demand.

Some retail caution is understandable. Emerging markets have looked like recovering on four separate occasions since the commodities crash in 2014, only to then turn sour. 

The latest blip was at the end of 2016, when the election of Donald Trump and a potential protectionist trade policy sent a 10-month recovery into reverse.

But this downturn was short-lived and markets have soared unimpeded in 2017. The grouping has shrugged off concerns regarding tighter US monetary policy, with two interest rate hikes and a commitment to unwind quantitative easing not unduly affecting returns. The weakening dollar throughout the year has also helped offset any concerns on this front.

Despite this increasing positivity, some investors are becoming cautious over the structure and distribution of returns. Like the US’s 12 per cent year-to-date return, emerging markets have become heavily reliant on a limited number of technology stocks. 

Asia’s trio of Baidu, Alibaba and Tencent – quickly becoming known as the Bat stocks – have dominated returns. The trio account for 10 per cent of the emerging market index, and have seen share price returns ranging from 40 to 102 per cent this year.

Schroders Asia-Pacific manager Matthew Dobbs has compared the trio to the US’s Fang stocks – the name given to Facebook, Amazon, Netflix and Google – noting a similar level of influence over overall returns.

Fund managers remain convinced emerging market corporates can continue to impress. Northern Trust Asset Management has tipped the sector for the strongest growth of any in its five-year forecast. 

The firm says emerging markets will offer a 2 per cent return premium to developed stocks.

“Emerging market equities are expected to enjoy 6.7 per cent revenue growth – three quarters of which comes from the emerging economies themselves,” the firm says.

However, it predicts that increased share issuance from developing world companies will take off 2 per cent from top-line returns.