Emerging markets remain relatively cheap despite a surge in popularity this year, according to Darius McDermott, managing director of Chelsea Financial Services. 
Many analysts have suggested that the emerging markets rally seen so far in 2016 looks set to continue for some time, with the developing world likely to move closer to developed world valuations.
A number of recent events have impacted the developed world this year, including the EU referendum in Europe and the Federal Reserve’s unwillingness to raise interest rates in the US, meaning emerging markets (which have returned 28.91 per cent so far this year) have outperformed the S&P 500 by 8.12 percentage points and the FTSE 100 by 16.79 percentage points.
However, emerging markets have struggled over recent years, having been the worst performing of the major indices over a five-year period as the below graph shows.
Performance of indices over 5yrs
Source: FE Analytics
While some suggest the developing world is moving away from cyclicality, and could be in-line for a longer period of outperformance, McDermott (pictured) says there is undoubted cyclicality to some of the emerging markets.
Despite this, he agrees that the developing world is “cheap compared relatively to developed markets and broadly cheap compared to its own history”.
“Things are broadly a bit better but the easy money has been made off the low [at the start of the year],” he said, making it more risky for investors than at the beginning of 2016, when emerging markets were extremely cheap.
With this in mind, below McDermott suggests two scenarios which investors may look at as positive for emerging markets, and which funds he would hold for these situations.
Value
The first driver for a sustained period of outperformance in emerging markets, he says, is if value comes back into favour globally.
“If you think global strong is going to be strong, that the dollar is not going to go against you and that emerging markets is in a sweet spot and China doesn’t blow up, then you might start to see a return to some decent value,” he said.
McDermott is not alone in this assessment, with George Iwanicki, Emerging Markets Macro Strategist, JP Morgan Asset Management agreeing.
“Emerging markets are beginning to look like a value opportunity. So far the nascent turnaround is largely concentrated in commodities, but that improvement may be broadening,” Iwanicki said.
“In our view, the asset class has gone from cheap value with a negative outlook to reasonably cheap value with an improving outlook.”
Value managers have underperformed in emerging markets but McDermott suggests M&G Global Emerging Markets and Lazard Emerging Markets as two that could outperform under this scenario.
Performance of funds vs sector and benchmark over 3yrs
Source: FE Analytics
Over the last three years, the funds have underperformed the MSCI Emerging Markets benchmark and their sector (IA Global Emerging Markets), as value has been out of favour for the last few years.
Lazard Emerging Markets, run by James Donald, holds a number of large technology companies, including Taiwan Semiconductor Manufacturing and Samsung Electronics, as well as a number of out of favour industries including the banks (China Construction Bank and Banco Do Brasil)
The £861m fund, has been third quartile over three and five years, but over a 10-year track record, it is top quartile, returning 125 per cent to investors.
Recently, the fund has performed in the second quartile over one year, while over six months it is in the top quarter of its sector.
Meanwhile, M&G Global Emerging Markets, run by Matthew Vaight, also holds banks (Axis Bank) as well as a number of other out-of-love industries such as financial services and commodities.
The £1.6bn fund is bottom quartile over three years but, like the Lazard fund, has performed better over one year and six months.
McDermott said: “They have started to do better this year – if you look at three year numbers you would ask what I’m talking about but these are funds with proven alpha generation, long-term track records and solid management so they could be really interesting.”
Growth
Growth and quality have been “in vogue” for a number of years, not just in emerging markets but globally, and McDermott says there is the potential for it to continue.
“If you think that is going to continue things like Newton Global Emerging Markets [might be worth looking at],” he said. “We’re also fans of Somerset Emerging Markets Dividend Growth fund.”
Performance of funds vs sector and benchmark over 3yrs
Source: FE Analytics
The five crown-rated Newton Global Emerging Markets fund, run by Rob Marshall-Lee since 2013, has been top quartile over one, three and five years.
The £73m fund is in the top quarter among its peers for risk-adjusted returns (as measured by the Sharpe ratio) and is in the second quartile for volatility over the last three years.
Meanwhile, the four crown-rated MI Somerset Emerging Markets Dividend Growth fund, run by FE Alpha Manager Edward Lam, has outperformed over five years, but struggled over the last 12 months.
The £1.1bn fund currently yields 2 per cent and has an ongoing charges figure of 1.3 per cent, and while it underperformed this year, McDermott says its income focus makes it appealing.
