It is a well-known fact that emerging market equities have been out of favour for a number of years now.
Thanks to slowing economic growth, falling commodity prices, geo-political tensions, currency weakness and the impact of US monetary policy on certain developing economies, funds in the IA Global Emerging Markets sector have underperformed against the MSCI AC World index by a hefty 50 percentage points over the past half a decade.
Performance of funds versus sector over 5yrs
Source: FE Analytics
That trend did show signs of reversing in 2015, though.
As a result of the Shanghai-Hong Kong Stock Connect programme and monetary easing in China, the new pro-reformist government in India and rebounding equity markets in countries such as Russia and Brazil, the sector got off to a flying start to the year and was up 14 per cent by April.
But, as so often has been the case over recent years, the asset class has sold off considerably recently and is down more than 6 per cent over the last two months.
Performance of sector versus index in 2015
Source: FE Analytics
While investors have often been told global emerging market funds offer decent opportunities over the long term given the areas of growth they tap into, the majority of industry experts warn that sector will continue to go through a painful period for some time to come.
Ben Conway, fund manager at Hawksmoor, reduced his exposure to the sector earlier in the year and, with the prospect of an interest rate rise in the US on the cards, he sees no reason to buy back despite the recent falls.
“We’ve had the view that the dollar would strengthen. While we had liked emerging markets funds from a valuation standpoint, the fact that the dollar and emerging market equities have been negatively correlated in the past meant we started to reduce our position.”
He added: “There has been nothing since then to suggest that wasn’t the right decision.”
While growth in the US has been weaker than expected, the consensual view is that the US Federal Reserve will look to raise interest rates this autumn, which should cause the dollar to strengthen further and create further headwinds for emerging economies. As a result, Conway says investors need to think very differently about emerging markets than they have done in the past.
He says that though funds in the IA Global Emerging Markets sector have comfortably outperformed those in the likes of the IA UK All Companies, North America and Europe ex UK peer groups over the last 10 years, they shouldn’t expect that to continue.
“The thing with emerging market equities is that investors need to be more sophisticated as you can’t generalise anymore,” Conway said. “There are so many different economies moving in their own separate ways. In many ways, the easy money has been made.”
The manager does own one fund within the sector, however, though it only makes up a small proportion of his portfolio.
“We hold Mark Vincent’s Standard Life Global Emerging Markets Equity Income fund which makes up 1.6 per cent of our Vanbrugh fund. The reason why we like it is due to the quality of the manager and because it is a bottom-up approach.”
He added: “The fact that we don’t own more of it in the fund is a recognition of the fact that even bottom-up managers, who are picking companies no-matter what is happening on a macro level, are going to struggle.”
Vincent launched the £361m Standard Life Global Emerging Markets Equity Income fund in December 2012, over which time it has been a top quartile performer with returns of 17.97 per cent. Our data shows it has more than doubled MSCI Emerging Markets index’s returns as well.
Performance of fund versus sector and index since Dec 2012
Source: FE Analytics
The fund, which yields 2.95 per cent, holds 25.8 per cent in China/Hong Kong, 11.9 per cent in Taiwan and 9 per cent in Korea.
Rob Morgan, pensions and investment analyst at Charles Stanley Direct, agrees that investors should be avoiding funds within the IA Global Emerging Markets sector.
“I’m generally of the view of the need to tread carefully. Some areas are attractive but quite expensive like India, others unappealing but very cheap such as Latin America. I also agree that the US dollar headwind could continue for some time and cause many of these markets pain,” Morgan said.
That’s not to say that Morgan is avoiding the developing world altogether, though, as he says Asia funds look attractive at this point in time.
“I would, however, be taking this opportunity to look at Asia, my favourite fund in the area being Aberdeen Global Asian Smaller Companies,” he said. “This contains quite a lot in ASEAN nations and its one to keep tucked away for the long term and add to on weakness in my view.”
“I was bullish on China last year on the basis of valuations but given the market has risen so much in a short space of time I am wary of a pull back; another reason to favour the Aberdeen fund as it has little mainland China exposure.”
The $3.2bn Aberdeen Global Asian Smaller Companies fund is headed-up by the highly-rated Hugh Young and his team based out in Singapore.
According to FE Analytics, it has been a top decile performer in the IA Asia Pacific ex Japan sector and has comfortably beaten its MSCI AC Asia Pacific ex Japan Small Cap benchmark since its launch in March 2006 with returns of 195.65 per cent.
However, like other Aberdeen funds, it has struggled over more recent time frames as a result of its underweight position in China and the manager’s focus on high quality growth companies. Our data shows it is bottom quartile over one and three years, for example.
Performance of fund versus sector and index over 3yrs
Source: FE Analytics
Nevertheless, given the quality of the team and the fact the fund’s holdings have been going through a period of weakness relative to other areas of the market, Morgan thinks now is a good time to buy in.
The team at Whitechurch also agree with Conway that investors should now be selling their global emerging markets exposure but, like Morgan, they think now is a good time to be invested in Asian funds.
“We have pulled back on our emerging market exposure, preferring to increase our position towards Asian equities, particularly with managers who favour Chinese and Indian markets,” Whitechurch said.
“Most of the major Asian markets are net oil importers, so a lower oil price should prove beneficial to Asian economies whilst if the Chinese implement pro-growth policies in the second quarter this should prove beneficial for the region.”
