There has long been the view that if an investor wants growth and strong outperformance, they should turn to an emerging market fund over one which focuses on the likes of the US, Europe, Japan or the UK.
Regular FE Trustnet readers will have by no means missed this, given that whenever we write articles looking at funds for an investor with a long-term time horizon at least one of them will have some exposure to the developing world.
The reasons behind such an assessment have been well-documented. Firstly, there is the increasingly wealthy middle-class in these economies, you can find stronger economic growth than in the developed world (although it is slowing) and they have a younger population than western nations which means stronger demographics.
On top of that, there is the belief that emerging markets have been a long-term investor’s best friend in the past. Surely, all things being equal, emerging markets should be a no-brainer for long-term outperformance?
Well, I was asked to speak about this subject at FE Trustnet’s most recent ‘Select Event’ where we put some of FE Research’s best-rated fund managers in front of a number of the highest profile wealth managers, discretionary fund managers, analysts and advisers in the industry.
The theme, as you can imagine, was global emerging markets and Asia Pacific ex Japan and my task (given that we at FE Trustnet are slightly obsessed with funds) was to present on some of our most interesting findings when we have written about the asset class in the past.
First things first, the point that has to be made is emerging markets have not been a great place to invest over recent years.
Source: FE Analytics
The reasons behind this underperformance have, again, been well-documented.
Sentiment towards emerging markets has increasingly worsened over the past half a decade thanks to issues such as China’s slowing growth, falling commodity prices, geo-political tensions, a stronger US dollar and the potential for tighter monetary policy in the US. All in all, it’s been a bit of a perfect storm.
What it means is, thanks largely to the events of the past six months or so, the IA Global Emerging Markets sector has managed to lose 10.2 per cent over the last five years. The average fund in the IA UK All Companies fund, on the other hand, is up more than 55 per cent over that time.
But, how important is five years? Many asset classes have delivered terrible returns over that sort of time frame but have still gone on to post phenomenal gains over the longer term.
Well, actually, this last five years has been so painful it is starting to wash away previous outperformance.
As the graph below shows, the significant outperformance of emerging market funds relative to UK funds in the years leading up to (and immediately after the crisis) have now been massively diluted.
Performance of sectors over 10yrs
Source: FE Analytics
While the average IA Global Emerging Markets fund is still ahead of the IA UK All Companies sector, it is now underperforming the likes of the IA North America and IA Europe ex UK sector over the past decade.
In fact, the emerging market sector now ranks 13th out of the 17 equity-only peer groups in the Investment Association universe over the last 10 years.
While that may come as a surprise to many (most delegates at the event thought the sector had performed far better than it has), what is more surprising is that even over 20 years emerging markets have struggled relative to their developed rivals.
Performance of sectors over 20yrs
Source: FE Analytics
Periods such as the last five years, the global financial crisis and the Asian financial crisis of the late 1990s mean that the IA Global Emerging Markets and IA Asia Pacific ex Japan sectors have now underperformed the average UK fund by 74 and 102 percentage points, respectively, over the last two decades.
So where does this myth surrounding emerging market’s long-term outperformance come from? It seems that investors who were promised long-term growth have been hindered by backing emerging market funds over those which focus on the domestic market.
That is a relatively naïve statement, of course, as I’m simply talking about averages.
While talking about sector averages can be helpful, there are emerging market funds which have delivered far in excess of the mean and in an article next week we will be taking a closer look at subject of active management in developing world equities.
In the meantime, though (and from a purely top-down perspective), is now the time to buy emerging markets following their years of underperformance?
We all know there have been a number of ‘false dawns’ and ‘dead cat bounces’ within the asset class over recent years.
Indeed, when FE started planning this event six months ago it seemed optimism would be high towards emerging markets given they were outperforming relative to the UK, US and Europe during the early months of 2015 after years in the doldrums.
Since then, of course, people have become even more negative on the asset class thanks to a China-induced sell-off which has hit global equity markets.
There are also clear and present threats to emerging markets, with China facing the unenviable task of changing its economic model from being investment-led to consumption-driven while concerns still persist that a rise in US interest rates will cause crisis in the developing world.
Psigma’s Tom Becket summed up opinion towards the asset class very well in a recent FE Trustnet article: “Emerging markets are hated, China is finished and resources are an arcane investment choice.”
Therefore, when it comes to answering the ‘is it a buying opportunity’ question, I’ll leave it to those who are far more qualified than me. However, there is evidence to suggest that the outlook may be improving.
First of all are valuations. Data from Bloomberg shows that the MSCI Emerging Markets index is trading on a far lower P/E ratio than the MSCI Developed World index at the moment.
Source: Bloomberg
While they are more expensive than they were at the worst of the Asian financial crisis in September 1998 and the difference in valuations is by no means as wide relative to developed markets as it was 17 years ago, it is also true recent policies such as ultra-low rates and QE have inflated most markets.
On top of that, emerging market economies are now very different beasts than they were in the late 1990s (they are more developed and have far greater reserves) and therefore it could be argued they are worthy of a higher valuation today.
History doesn’t repeat itself, but (apparently) according to Mark Twain, it tends to rhyme and we have seen this sort of underperformance of emerging markets relative to the developed world in the past – namely during the depths of the Asian financial crisis which I have just mentioned.
While it is over a shorter time frame, both the IA Global Emerging Markets and IA Asia Pacific ex Japan sectors lost 49 and 55 per cent, respectively, between May 1997 and September 1998 while UK funds made 11.72 per cent.
Performance of sectors during the Asian financial crisis
Source: FE Analytics
That is the same 50-plus percentage points difference in returns (albeit the other way round) that we have seen between emerging markets and UK funds over the past five.
Interestingly, after that very tough period, the IA Global Emerging Markets sector went on to deliver gains of 406.89 per cent over the next 10 or so years up to May 2008 while the IA UK All Companies sector made 71.86 per cent.
Yes, those dates are slightly cherry-picked given the global financial crisis started to kick in immediately after that period.
Nevertheless, if an investor had managed to time the bottom of the Asian financial crisis they would still be well ahead of UK funds despite the relatively disastrous last five years for emerging markets, as the graph below shows.
Performance of sectors since the Asian financial crisis
Source: FE Analytics
There is also evidence to suggest that sentiment towards emerging markets may be about to change.
While most of the delegates at the event were either neutral or underweight the asset class in their client portfolios, many of them expect to be overweight over the coming 12 months given how far emerging markets have fallen over recent years.
Of course, circumstances can change and there still seems to be a variety of reasons why investors should avoid emerging markets at the moment.
But it seems hard to imagine that they will consistently lose out to developed markets given that factors such as an increasingly wealthy middle class, better economic growth and stronger demographics are all still true.
However, for those wanting to buy in now for long-term outperformance, let’s just hope the past doesn’t turn out to be a guide to the future.