Emerging from the shade

It wasn\'t so long ago that investors were waxing lyrical about emerging markets. Performance figures were mouth watering, with Latin American funds leading the way delivering returns in excess of 300 per cent over a three-year period to 2006.

Latin America’s economy was growing, helped by strong commodity prices and buoyant demand from China. It is a region rich in raw materials: Venezuela has oil, Mexico and Peru have an abundance of copper and Brazil is rich in iron and steel. On the corporate side, companies had reduced their debt burden, become cash-generative businesses and focused on shareholder value for the first time. People were spending again following years of uncertainty and falling wages.

Gains were just as impressive in Eastern Europe, where returns in excess of 200 per cent were common. Russia was the driving influence. Political stability had attracted foreign and domestic investment, while a surging oil price buoyed its economy.

But the financial crisis has wreaked havoc on the emerging economies. The knee-jerk reaction from investors during times of uncertainty is to ditch the riskier assets – consequently their exposure to emerging markets is quickly reassessed.

“From the collapse of Lehman Brothers and its impact upon global liquidity, to the slide in commodity prices and their impact on national revenues, the knives were out for emerging market equities. As investors fled toward safe-haven assets, emerging markets suffered high-beta sales, falling in excess of their developed market peers,” says Alex Tarver, global emerging markets product specialist at HSBC Global Asset Management.

He adds: “Early expectations of downward revision for GDP growth prompted further sales, reinforcing investors’ avoidance of the asset class. Currency weakness relative to the US dollar only served to exacerbate investors’ pain, especially in the face of the impact upon country revenues of the aforementioned falling commodity prices.”

Performance has also trailed. Research from BNY Mellon Asset Servicing reveals that the average UK pension fund achieved a weighted average return of minus 13.6 per cent last year. Over the year, equity market returns were in negative territory for each of the key sectors, but the poorest equity performance came from emerging markets with a fall of 35.4 per cent.

Yet the appeal of emerging markets has not disappeared overnight and some investors are using the market falls as a buying opportunity. Julian Webb, head of UK DC at Fidelity, says: “We see some anecdotal evidence of members switching their asset allocation into riskier emerging markets funds, to take advantage of cheap asset prices and the possibility of more robust growth from those economies. However, this activity is limited to those with significant investment experience, and I would never advocate DC members use their pension pot to time markets.”

Emerging market funds use the MSCI Emerging Markets Index. As of January 2009 the MSCI Emerging Markets Index consisted of the following 23 emerging market country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

Emerging market advocates continue to believe that the decoupling from developed markets widen their appeal and makes them a worthwhile diversification play.

Evidence points to global emerging markets showing some signs of decoupling from the US and the rest of the developed world in the three months to the end of February. The median global emerging markets fund lost 5.9 per cent, around half the 11 per cent loss on the median global developed markets fund.

“Investors in emerging market equities lost money in this period, but significantly less than investors in developed markets,” says Alison Cratchley, lead analyst at S&P Fund Services. “Fund managers remain relatively positive on the longer-term outlook for emerging markets, with Asia their preferred region, mainly because of China.”

Michael Konstantinov, fund manager of the Allianz RCM BRIC Stars fund, believes that emerging markets could prove more resilient than their Western counterparts. He says that while equity markets in the emerging markets have suffered as a result of the global slowdown, financial systems in the BRIC (Brazil, Russia, India and China) markets are actually quite resilient.

“They are not subject to the investment difficulties that banks and financial institutions in the developed world are facing, such as toxic assets and troubles in real estate markets,” adds Konstantinov.

Experts insist that emerging markets’ economies are continuing to experience growth, albeit not at the breakneck pace of the past few years. And Latin America, an emerging market often overlooked by private investors, is gaining some attention, rather than the traditional favourites, Russia, India and China. Many believe that, having fallen more than 50pc of its peak, Latin America offers value.

First State is launching a new Latin America retail fund because it thinks now is the ideal time. Managers Jonathan Asante and Millar Mathieson will be investing their own money, such is their belief in the region, insisting it is not an asset gathering exercise. “It is not affected by credit issues because Latin American countries have had many crises before and didn’t lend. There are some good quality and reasonably valued companies that will benefit from any recovery,” Asante says.

Meanwhile, Simon Chinnery, head of DC at JPMorgan, says: “We favour Latin America and China – Brazil will benefit because it provides commodities to China for its expansion.”

The arguments in favour of emerging markets are compelling – particularly if you believe that India and China are suffering nothing more than a temporary dip due to the global recession.

According to the latest World Energy Report, the emerging nations – notably China and India – are going to continue to support and fuel energy prices for the next two decades. PricewaterhouseCoopers believes China should be able to sustain an average growth rate of around 6.8 per cent per annum in real dollar terms between now and 2050 (recent economic data supports the forecast that Chinese GDP growth will hit around 8 per cent this year). India should be able to sustain 8.5 per cent and Vietnam 9.8 per cent.

Andrew Merricks at Skerritt Consultants says: “I do not think that anyone can argue that the emerging world is not going to have a far more powerful voice in world affairs in the coming years, and as such it makes sense to invest – or be allowed to invest – in regions that are on the up rather than those that are in decline.”

The potential case for some exposure to the emerging markets sector for the longer-term investor is also borne out by the sector average for the last five years, showing returns of 73 per cent compared to only 10 per cent for the global equity sector.

Lee Smythe at Killik says: “Short-term losses for emerging markets have been correspondingly greater as well, but depressed valuations in global markets including the emerging sector can be beneficial to pension investors with lengthy time horizons, particularly to those making monthly pension investments, as the ‘pound cost averaging’ effectively reduces market timing risk compared to lump sum investors or those wishing to switch existing funds.”

Trustees are aware of the scope of emerging markets, but have to weigh-up the risk versus reward arguments for their members. Simon Chinnery, head of DC at JPMorgan, says that trustees he has met with recently are receptive to the arguments for emerging markets, but that they still make up a small part of portfolios.

He adds: “We have seen emerging markets have large falls before, but for the first time they are connected to global events – which shows the maturity. We are confident that they will beat all other markets over a ten-year time horizon.”

Most DC workplace schemes typically only offer limited access to emerging market funds. These would normally come in the form of one of the insurer’s own funds, likely to be a general ’emerging markets’ fund, plus potentially some external fund links to either a generalist emerging markets fund, such as Gartmore Emerging Markets Opportunities fund or First State Global Emerging Markets Leaders (which are common options across a range of the major GPP providers). Alternatively, more specific funds, such as Gartmore China, Jupiter Emerging Europe and Invesco Perpetual Latin America may be offered.

Open architecture means that many GPP schemes will offer emerging market funds, but Laith Khalaf at Hargreaves Lansdown says that it is important not just to have one emerging markets fund but to have a number of them run by different investment managers.

“For the majority of investors, going for a general emerging markets fund is the most appropriate – giving access to most regions. Mixing the First State Global Emerging Markets Leaders fund with the Ignis Hexam Emerging Markets gives a blend of both value and growth,” says Khalaf.

Many default funds – which the vast majority of employees opt for – will also have a small exposure to emerging markets anyway, workers need not worry too much about their asset spread.

Standard Life’s default managed fund for DC investors, for instance, invests 1.2 per cent in emerging markets at the moment, compared with the Lipper sector average of 2.4 per cent. This underweight exposure, says the Edinburgh-based insurer, reflects its house view “to be light emerging markets”. Like many companies, it does not offer a separate emerging markets fund for pension investors.

“The pension investor that will have some view on these markets is more likely to be sophisticated and perhaps access individual asset strategies via a Sipp. The majority of investors tend to go for the default managed fund, and it is appropriate that we can invest in these markets within this fund to take advantage of the opportunities that these markets represent,” says Chris Arnott, investment director, at Standard Life Investments. “The small percentage weighting, however, reflects the cyclicality, increased volatility and high beta exposure of these markets. Also we must bear in mind the currency, liquidity, accessibility, volume and how attractive emerging players may be relative to other markets.”

The overriding issue for employees and trustees is one of education, and whether the average employee is equipped to make a decision on whether to invest in emerging markets funds or not. HSBC reckons that only sophisticated employees make the most of emerging market options, which account for around 10 per cent of those actively investing for their workplace pension.

The big emerging market nations may be more mature, but they are still volatile and a long way from being moved out of the MSCI Emerging Market Index to a developed index.

“India, China and Brazil are not close to being developed markets. Korea was set to be taken out of the MSCI Emerging Market index and dialogue got to an advanced stage, but recent events soon put that on the back-burner,” says Emily Whiting, client portfolio manager, emerging markets at JPM.

It is the volatility that concerns many advisers, trustees and employers. Peter Cox at HSBC is also worried that employees may be led into emerging market territory but then left to their own devices. “If you are educating to active members that are making decisions, then you had better be sure to continue the education and guide them along away.”

Emerging markets generate excitement and can add spice to a portfolio, but their dangers are there for all to see. Novice Isa investors piled into Russian, Indian and Chinese funds off the back of stunning performance two to three years ago. One wonders whether they were chasing performance or diversification – but the timing was woefully wrong, as their Isa statements will now testify.

Perhaps it is asking too much of employees (particularly in contract-based schemes) to ponder using emerging markets for their pension fund. Or perhaps they don’t need to after all.

Webb says: “The irony is that up to 90 per cent of DC members may be exposed to emerging markets already via their default fund. This will either be through multi-manager products where the fund manager has taken a view on the asset class or, more simply, through any fund that tracks the FTSE 100.

“The UK’s benchmark index includes both UK companies that derive revenue from emerging markets, such as the oil giants, or companies like Antofagasta and Kazakhmys, which have their main operations in Chile and Kazakhstan respectively.”