The case for emerging market equities

AFR Investor, Sun-Herald/Sunday Age, May 2010

For the second time in two years, one of the engines of the developed world economy is in trouble, this time Europe. And also for the second time in two years, the countries we call emerging markets – those in the developing world in Asia, Latin America and Eastern Europe, for example – look much stronger than their supposedly emerged peers in the west.

At first glance, it looks like a reason to divert your international equity exposure away from places like the US and Europe, and towards places like Asia. The truth is, Asian economies – the ones we have patronised with the emerging label all these years – look in far better fiscal condition than any of the richer counterparts in the west, with the possible exception of Australia itself. “Asia is in better financial shape than it has ever been, and also relative to the world,” says Peter Sartori, who runs Treasury Asia Asset Management, which offers Asian equity funds to Australian investors. Most emerging Asian nations don’t have deficits of any note; they are in a demographic sweet spot in which the bulk of the population are working, and not entering retirement as in places like Japan; and in many cases their biggest challenge is keeping growth in check to avoid inflation, not wallowing out of recession.

The problem is, we’ve been here before. During the global financial crisis, there was a lot of talk that Asian countries had become so strong, they would not be affected by problems in the US. Unfortunately this turned out to be rubbish – although Asian economies stood up pretty well, foreign money fled emerging markets and most stock markets in Asia did even worse than those in the west (although they subsequently rebounded much more vigorously too). So with another crisis in Europe, should we expect contagion again?

Economists generally think not: only 20% of Asian exports go to continental Europe, and most of those to relatively unscathed Germany, meaning a European slowdown should have a modest impact. “While the sovereign debt crisis has increased the downside risks to EU growth, we do not think that it represents a large risk to emerging market Asian growth for now,” says Prakriti Sofat at Barclays Capital in Singapore, who also stresses that exports aren’t as vital to Asia as they used to be because of the growth in domestic demand.

Money managers familiar with Asia are wary. “Having been living in Hong Kong in 1997 and 1998, managing Asian money and witnessing how contagion spread, I’ll never underestimate what contagion could do across Europe,” adds Sartori. “But I find it quite hard to believe that contagion could spread to Asia. My general hope and view would be that Asia would come out of this in a much strong relative position.”

A look at performance numbers does suggest that, for all the volatility, emerging markets funds have been doing better than developed world equities, particularly in the rebound since the global financial crisis. According to data from Mercer, the median emerging markets equity fund sold in Australia delivered a 39% return in the year to March 31, 1.6% a year over three years (a period which includes the whole financial crisis) and 11.5% a year over five years. For overseas shares funds generally, those figures are 17.9%, -7.8% and -0.3% – considerably inferior on all counts, although the picture is much brighter for hedged overseas funds (those that neutralise currency movements).

In fact, much discussion in Asia has focused not on threats to growth, but worries that growth is getting out of hand. The IMF recently warned about the volumes of inflows into Asia, and the creation of asset bubbles, particularly in Chinese property.

Is this a worry? “There are various bubbles in Asia,” says Hugh Young, managing director for Asia at Aberdeen Asset Management. “But they are largely property-related, not really stock markets, although they are due a fall after rapid rises. Famous last words, but there are no huge excesses in most of Asia, though markets are far from cheap.”

That’s another important point: after such terrific rises in most Asian markets in the last year, is it a good time to buy? Even long-standing Asia bulls like Sartori will only say: “Overall, we think Asian stocks can end the year higher than where they are at the moment”; he is actively avoiding India and Indonesia, finding them overvalued.

Credit Suisse Asset Management starting pulling out its emerging Asia equity exposure last November, feeling valuations were getting stretched, and instead getting its exposure by buying developed world companies which get most of their revenues from emerging markets (another popular approach – many people buy stocks such as Coca-Cola, Nestle or even BHP Billiton for exactly this reason). But, according to senior advisor Robert Parker, valuations are “starting to look more reasonable. My view is after the next two to three months we will want to go back into emerging market equity.” He favours Korea, Taiwan and – despite valuations – Indonesia.

It’s important to note that different Asian markets appear to offer different opportunities at different times. Sartori is overweight Taiwan, for example, which in recent years has thawed its previously hostile relations with China, a thawing that ought to have considerable benefits to Taiwanese industry and banking. Also, he notes that China – despite what you read about its phenomenal growth – has been a hopeless stock market performer; its CBN 600 index was down 21.8% in 2010 up to May 17. “Chinese stocks have underperformed for three quarters now and have de-rated. But we’re in the camp that is not overly concerned about China: we think the weakness is throwing up a lot of buying opportunities. Although, saying that, we’re not even close to buying a real estate stock there.”

This raises the question of how to invest in Asian or emerging markets. There are a number of ways.

The most obvious is to buy an emerging market or Asia mutual fund. Morningstar tracks 76 separate emerging market equity managed funds sold in Australia, although many of them are different sales classes of the same fund; they vary from covering all emerging markets (such as the Russell Emerging Markets Fund, up 32.36% in the year to April 30); ex-Japan Asia (such as the T Rowe Price Asia ex-Japan Fund, up 41.91%); BRICs – that handy acronym covering Brazil, Russia, India and China (such as the Macquarie Globalis BRIC Fund, hedged, up 42.23%); or country-specific (such as the Fidelity Indian Fund, at 62.97% the best-performing emerging markets fund over 12 months in Morningstar’s coverage by a mile, and the Premium China Fund, up 33.66%). Each individual fund will have its own allocation overweights and themes, and their views and successes will make a quite a difference to returns: Morningstar tracks some emerging market products that made only single figure returns in the same year that Fidelity was shooting the lights out with its India fund.

Emerging markets is the broadest approach. To take the Templeton Emerging Markets Fund as an example – probably the most famous in the world, thanks to its iconic manager Mark Mobius – as of March 31 this would have put 22.2% of your money into Brazil, 15.8% into Russia, 15.3% into India, 11.3% into China, and then smaller chunks into places like South Korea, Turkey, Hungary, Mexico and Indonesia.

At the other extreme, country specific funds are offered in Australia on China (by Aberdeen, AMP, Fidelity, Premium and Challenger), and India (Fidelity and Fiducian). These allow you to take a view on a particular Asian market, but don’t offer a lot of diversification.

It’s also possible to go it alone. Many Australian brokers allow you to buy securities on the New York Stock Exchange, which allows you access to the many Asian countries that have listed forms of their shares (called American Depositary Receipt listings) there – among them Chinese banks, oil companies, telcos, and a host of other regional blue chips such as Taiwan Semiconductor Manufacturing or Samsung Electronics. Some brokers let you buy shares in Hong Kong and Singapore too. Alternatively iShares offers exchange-traded funds in Australia, bought and sold like any other local share, which replicate the performance of indices including China, Taiwan and Korea, as well as ‘emerged’ Asian markets Singapore and Hong Kong.

Doing your own investing in Asia, though, is not to be taken lightly. It’s hard enough to keep track of what Australian companies are doing without seeing your way through companies in different countries, time zones and corporate cultures.

One thing that has severely damaged the benefits of international share investing for Australian investors in recent years has been the outstanding performance of the Australian dollar against dollar, euro, sterling – you name it. But how about Asia? “We think Asian currencies will appreciate, particularly against the Australian dollar, which is crucial for Australian investors,” says Sartori. Judging currency movements, though, is exceptionally difficult, and many managers hedge it out altogether.

In future, perhaps we won’t talk of emerging markets; everything about the performance of world economies in the last few years has supported the sense that the West is certainly no smarter than the East, and in a much worse financial state. “I don’t particularly like this categorisation of developed market, emerging market, frontier market,” says Parker. “There are many economies categorised as developed which frankly I would call emerging, and likewise some emerging markets I think are developed. The classification is just plain wrong.” But whatever you call it, it’s where the money is going. “You’ve got a quantum change in investor attitudes towards emerging markets,” he says.

BOX: Emerging debt

It’s not just in equities that many people see emerging markets as the best option. Many global fund managers are looking here for the best options in debt too.

“We are long emerging debt,” says Robert Parker, senior advisor for Credit Suisse Asset Management, which manages SFr1.3 trillion worldwide. CSAM starting pulling money out of G3 sovereign debt – in currencies like dollars, euros and yen – and putting it into emerging markets in late 2008 and continues to do so.

At Goldman Sachs Asset Management Asia, Oliver Bolitho, who heads the business, has a similar view. “Given the uncertainties about the ratings and fiscal positions of many OECD countries, there is a strong case to be made that the debt of emerging economies is an extremely attractive proposition,” he says. When Asia’s corporate bond markets develop further, Bolitho expects opportunities to increase, “and those opportunities will remain very attractive, possibly for decades.”

Australia does not, though, offer many ways of buying emerging market bonds in managed funds sold there. Instead, they can opt for funds which allocate more than most towards emerging markets while balancing it with some more stable developed-world government debt or with broader global high yield. A good example of this is the Pimco Extended Markets Fund, sold in Australia to retail through Equity Trustees, which is benchmarked half against an emerging markets bond index, a quarter against an emerging market government debt index and one quarter against a global high yield index. As of March 31 its top holdings were debt in Brazil, Russia, Mexico, Indonesia and the Philippines, and its total net return (distribution plus growth) in the year to that date was a remarkable 39.51%, although the five year average of 8.59% a year is probably a more realistic reflection of how a fund like this ought to return.

Remember, though, that returns come with risks; and while many feel that risk-reward ratio has tilted in favour of emerging market debt, it’s still nothing like owning a Commonwealth bond in Australia.