Fund Selector: How to gain exposure to EM

With the recent cyclical upswing in the global economy, many people have been looking to re-allocate to emerging markets, where valuations are compelling for those who can tolerate the higher risk that comes with them. 

There are a number of ways to gain exposure to the sector, whether that be through fixed income or equities directly in emerging markets, or through companies based in developed markets deriving profit from the space.

While all of these routes are valid, I will just focus on what I look for when investing in emerging market equity funds for client portfolios.

First and foremost, I’m looking for managers with an established record of adding value over time, and who can help preserve capital in this particularly volatile asset class.

While the long-term economic potential of emerging markets is hard to dispute, achieving an investment return from this growth is far from straightforward. There is no guarantee that equities gain as GDP rises, particularly in regions where free market regimes have not been the norm.

A key example is China, where from 2001 to 2005 – a period of strong growth that saw GDP increase from 9.5 to 12.4 per cent a year – the domestic A-shares market lost 51.7 per cent, as measured by the MSCI China A index.

Achieving reproducible positive performance requires careful and detailed due diligence on underlying companies to ensure there is a genuine investment thesis, rather than simply being drawn in by an appealing narrative.

There is also the challenge of stocks in the mainstream, market-cap-weighted benchmarks. Traditional emerging market equity indices are often considered especially unattractive investment options, filled with state-owned enterprises.

Such lumbering beasts are typically inefficient extensions of the state: political entities that rarely add much value for external investors.

At the same time their size means they can have heavy weights in market-cap-weighted indices, which are often routes for hot money flows.

When I invest into emerging markets I’m looking for entrepreneurial and profit-seeking companies, not Chinese state banks or oil and gas giants in Russia and Brazil. As a result, it often pays to look for patient managers with flexible mandates and a track record of finding high-quality companies that can be held for the long term.

In a volatile region, a conservative and sustainable investment approach can help to cut through a lot of the noise to find genuine value. Firms that pay a dividend can also be an attractive option, not because of the income specifically, but as an indicator of good corporate governance and a long-term outlook.

Emerging markets offer a lot of potential for talented and suitably resourced fund managers. It is important for me that managers are buying stocks with a clear bottom-up investment case, and have a long time horizon.

Investors, too, should be patient – funds with the attractive long-term potential may underperform over short time periods, particularly when hot money is indiscriminately driving up index names.

Savvy investors may take this as reaffirmation of a durable investment strategy.