Over the past year, as markets have rallied, the average fund in the IMA Global sector has made 13.92 per cent, more than double the 6.68 per cent made by the average emerging market fund.
Over three years the difference widens to three times, with the global sector returning 21.14 per cent against the 9 per cent of the IMA Global Emerging Market sector.
Performance of sectors over 3yrs
Source: FE Analytics
Industry experts say that this outperformance could well continue while the global economy remains in a sluggish mode, raising the question whether investors should diversify into global funds to benefit.
According to Arjen Los, manager of the Dominion Global Consumer Trends fund, which sits in the IMA Global sector and invests in Western companies selling into the developing world, the underperformance of the emerging markets is a combined effect of two factors.
“The first one is related to the sensitivity of growth markets to changes in sentiment and expectations. A small change in expected future growth has a big impact on current valuation,” he said.
“Second, developed markets benefited from a bounce back after the credit crisis.”
Charles Heenan (pictured), manager of the S&W Kennox Strategic Value fund, stresses that the sensitivity of emerging markets makes them more cyclical.
“Emerging markets are more reliant on industrial goods and manufacturing, which tends to be more volatile, so they “boom” and “bust”; when everybody is buying stuff they do better,” he said.
Adrian Lowcock, senior investment manager at Hargreaves Lansdown, agrees that emerging market growth remains highly sensitive to what happens in the West.
“The key factor comes down to what drives emerging markets, and it’s principally Western money,” he said. “Hot money flows in when confidence returns and what you have had in the past few years is risk-on and risk-off markets, and Western money tends to flow in when risk appetite is high.”
“Over the past five years, whilst everybody talks about decoupling and a low-growth West and high-growth developing markets and the West languishing on an economic level, the money is still in the West.”
Lowcock (pictured) explains that this means that sentiment in the West has a high bearing on investment in the developing world and therefore stock market exposure.
“The other thing is that everybody is getting more aware that economic growth is not stock market performance,” he added.
This raises the question whether investors should diversify some of their emerging market holdings into a global fund to benefit from this strong performance.
However, Lowcock points out that the best managers in the emerging markets have massively outperformed their indices.
“Emerging markets as an asset class hasn’t delivered but there are a couple of exceptional managers like Aberdeen and First State,” he said. “What’s average is not necessarily what you are investing in anyway.”
Data from FE Analytics shows that the best fund in the emerging markets sector – Aberdeen Global Emerging Markets Smaller Companies – has significantly outperformed the best active fund in the IMA Global sector – the Morgan Stanley Global Brands fund.
However, the Morgan Stanley fund has only marginally underperformed the best-performing large cap fund in the emerging markets sector over that time.
First State Emerging Markets Sustainability has made 47.74 per cent while the Morgan Stanley fund has made 45.8 per cent.
Performance of funds versus sectors over 3yrs
Source: FE Analytics
The pattern is the same over five years: over that time First State Global Emerging Market Leaders has outperformed the Morgan Stanley fund by just 2 percentage points.
However, Lowcock says that a global fund may not even be necessary to take advantage of the strong performance of the sector if it continues.
Global funds typically buy stocks in a number of developed markets, often with a high weighting to the US – the best-performing index of the year so far.
But Lowcock points out that most investors already hold funds that focus on this area anyway.
“A lot of people tend to have a diversified approach to equities already, so they have a UK fund, an US fund and don’t necessarily need a global fund,” he said.
“You can get some good managers in the regions. You may be overlapping some of your other holdings.”
“Plus the expertise needed to run a truly global fund is more extensive than if you are a UK fund, so there are fewer good funds.”
He says that the funds might be a good way for first-time investors to start building the core of a portfolio.
“It’s a good way for new investors to start investing in higher risk areas. You can get exposure to the higher growth markets with diversification. They can then end up acting as a core to a portfolio in the future.”
Heenan says that while he has been avoiding investing in emerging markets directly on valuation grounds, he does look for Western companies selling into these regions, and he still thinks that emerging markets are the place to be for long-term growth.
“My view is that the emerging markets are an interesting place in the longer term,” he said.
“They are likely to grow faster but we would anticipate the growth will be “choppy”, so when they grow they will grow faster but they will be more volatile.”
As well as the cyclical sensitivity of emerging market economies, Heenan adds that the emerging markets lack “automatic stabilisers” such as unemployment insurance, which ensure money keeps flowing when the economy dips.
“This means the markets are more likely to boom and bust, but we still think they will grow faster,” he said.