Smart Investor: Getting Started, August 2013

Smart Investor, August 2013

Getting Started

The appeal of investing in emerging markets is that it provides you with exposure to the engines of world growth: the places where countries haven’t yet saddled themselves with unmanageable debt, where the demographics are dominated by young working-age people rather than those slipping into pension-drawing retirement, and where the question is how much an economy will grow by each year rather than how much it will shrink.

There are many ways Australians can invest in emerging markets. The most obvious is through a mutual fund or ETF focusing on emerging market equities – either emerging markets broadly (which tend to be dominated by Asia, with some allocations to Eastern Europe, Latin America, and at the margins Africa), through region-specific Asia funds, or through single-country funds, typically focusing on China.

So, for example, big Australian fund managers including AMP, BT, Colonial First State and OnePath all offer emerging market equity funds, with the management often subcontracted to a specialist. Foreign fund managers with representation in Australia, such as Schroder, Aberdeen, Templeton and UBS, also offer their own emerging market equity funds. Many of these also offer Asia-only funds, as do some other big names including Australia’s Platinum and TAAM, and global leader T Rowe Price. And Aberdeen, Fidelity and Perpetual are examples of managers offering China-specific funds.

 On top of that, exchange-traded funds offer index exposure without stock selection. In particular, iShares has Australia-listed funds for emerging markets, Asia, the BRICs (Brazil, Russia, India and China), China, South Korea and Taiwan, among other places.

Emerging market bonds are harder to access, but such funds are sold in Australia: Pimco’s emerging markets bond fund is sold in Australia through Equity Trustees, for example.

So access is not a challenge. But recently, a problem has emerged: emerging markets aren’t doing what they’re meant to.

By June 9, the S&P 500, measuring US stocks, was up 14% so far in 2013; the MSCI Europe was up 5%. But the MSCI emerging market index was down 4% (all of these are in US dollar terms). In particular, China was down 6%. Instead of flowing into these markets, money is fleeing: there were US$3 billion of net redemptions from emerging market funds globally in May, according to EDFR Global, the data provider.

Why should this be, when China is expected (by the World Bank) to grow at 7.7% this year, and the European Union is expected to shrink by 0.1%?

One important thing to understand is that economic growth does not automatically translate to strong economic performance. Investors in Chinese equities have had to deal with this disparity for many years, with several occasions when terrific economic growth has coincided with a fall in stocks. Also, it’s a question of momentum: China might grow at 7.7%, but that rate is slowing, and is likely to slow more. In contrast, the US and (though further behind) EU are working through their problems and there is a feeling of progress that is being rewarded by the stock markets. Some fund managers think that we are in a multi-year period of underperformance of emerging markets relative to developed ones.

Partly for this reason, and partly because of transparency and familiarity, many people believe the best way to get emerging market exposure is not actually to invest in emerging market companies at all, but international blue chips which earn a large proportion of their revenue from the emerging world. Coca-Cola in the US and Nestle in Europe are the two most commonly cited examples, while an Australian equivalent would be BHP Billiton, and perhaps for the future, ANZ.

At the same time that emerging market equities have been falling, investors have become increasingly worried that emerging market bonds – which have performed extremely well – have turned into a bubble. Money has flooded into these assets for many years because they offer a high yield, and because emerging economies have increasingly looked robust compared to western peers. But there has always been a concern that all that money might leave again one day and the bubble might one day burst.

And the biggest impact on these bonds has nothing to do with the emerging world, but the US and its long-standing scheme of quantitative easing – the process of the US Federal Reserve buying bonds and other securities in a bid to stimulate the American economy. The US has launched three rounds of this so far, but has recently started talking about tapering off its QE programmes. The effect of this has been to cause investors to pull money out of emerging markets as yields have started to rise on US Treasuries.

So, with all that said, should you consider investing in emerging markets? Well, the key is to think for the long term. Logically, stronger economic growth should mean more companies with improving earnings and better stock market performance over time. And the demographics are absolutely unarguable: the place with the young labour force, without an elderly retiree community to report, should have the best earning profile too. But as with all investments, patience is key, and emerging markets – whether bonds or stocks – should only be used to diversify a portfolio, not as the main part of one.