After a torrid five years, emerging market equities have witnessed a dramatic reversal in fortunes in 2016. 
Year-to-date the MSCI Emerging Markets index has gained 39.27 per cent in sterling terms on the back of better signs from China, firmer commodity prices, and a more dovish tone from the Federal Reserve.
At this point the index is some 14 percentage points ahead of developed world equities, which is in stark contrast to the situation of recent years.
Of course, the pound’s Brexit-induced plunge has bolstered those gains for UK-based investors, but emerging markets have also outperformed from a US dollar perspective as well.
Performance of indices in sterling over 2016
Source: FE Analytics
With such sharp gains, you might expect euphoria – but it has been notable by its absence.
Interestingly, closed-ended funds have also underperformed their open-ended rivals in the emerging market space – a phenomenon that our analysis shows is largely the result of open-ended funds’ tendency to track or amplify the performance of the index; lots of OEICs are closet trackers, in other words.
Given the large gap that has opened up between NAVs and prices, we think this is an attractive entry for emerging markets and believe there are a number of trusts which work well in a variety of potential outlooks for the sector.
Dull NAV returns from investment trusts
First though, it’s worth highlighting how emerging market investment trusts have performed during this rally.
Our data shows the average trust in the Global Emerging Markets sector is up 28.3 per cent over the year to date, underperforming the index by a chunky 7 per cent. It’s a similar story for the Asia Pacific ex Japan sector where the peer group is on average up 30 per cent this year, while the MSCI AC Asia Pacific ex Japan index is up 31.3 per cent.
The average open-ended fund has outperformed the average trust over the period, even though trusts have the supposed advantage in a bull market of gearing.
Source: Investment Trust Intelligence
But closer analysis of these indices and the drivers behind their performance shows that the influence of ETF money – and the prevalence of trackers and closet trackers in the open-ended sector – has played its part.
A closer inspection of open-ended fund outperformance
We believe open-ended funds have performed better because more of them are (effectively and actually) tracking the index, and that the indices themselves have seen significant mean reversion. Much of what performed poorly last year has performed very strongly this year.
The peer group includes a number of funds which are pure trackers and these have dominated the peer group’s second and first quartile year-to-date.
In fact, passive funds have performed better than their active counterparts; the average tracker in the sector has beaten the average active fund by 4 per cent in 2016 so far, with a return of 38.27 per cent.
Further, closer examination of ‘active’ OEICs in the sector reveals that the best performing funds over the period are dangerously close to ‘benchmark hugging’ or ‘closet tracker’ territory.
For example, the top 10 performing active funds in 2016 have on average over the past three years had a beta of 0.96 relative to the MSCI Emerging Markets index, so returns have been highly sensitive to the benchmark’s movements.
They have generated very little alpha at 0.48 and have produced a tracking error of 4.5 per cent - a very narrow figure for an ‘active’ fund.
Commanality among their holdings is rife.
The five most popularly owned stocks among them are Samsung Electronics, China Mobile, Taiwan Semiconductor, Naspers and Sberbank of Russia - four of which are among the six largest stocks within the MSCI Emerging Markets index and, as a group, this cohort of holdings has returned 57.9 per cent in 2016 in sterling terms - making a significant contribution.
Further evidence of the limp contribution which management skill is making in the open-ended sector is provided by their performance in the three years prior to 2016 – clearly a very difficult period for the developing world and a time during which ETF flows were negative rather than positive.
Source: Investment Trust Intelligence
Data shows, on average, those 10 funds lost 15 per cent in total return terms, while the index fell 10 per cent.
Investment trusts in the IT Global Emerging Markets sector, on the other hand, only lost 2.5 per cent in NAV terms over that turbulent time.
The drivers of the rally
What we are seeing is effectively mean reversion.
The emerging market rally of 2016 has been driven by some of the biggest and previously most bombed-out areas of the index. Samsung Electronics, which is the largest member of the index, has rallied a staggering 80 per cent already this year.
Sectors such as mining have driven the index as well in 2016; the sector is up 73 per cent, having fallen 35 per cent last year as commodity prices nosedived. On the other hand, more defensive sectors such as consumer staples and healthcare (which performed the best during last year’s rout) have underperformed the index this year with returns of 26 per cent.
Emerging market investment trusts – which as a collective group have performed better in NAV terms during tougher market conditions than their open-ended counterparts – have been left behind as most have avoided the largest constituents of the index.
Discounts
This underperformance of investment trusts has, rightly or wrongly, had a profound effect on discounts within the emerging market closed-ended fund space.
Despite the fact that developing world equities have rallied significantly (and most trusts in the space have delivered decent NAV gains in absolute terms), the average discount in the IT Global Emerging Markets and IT Asia Pacific ex Japan sectors has hardly changed this year.
In fact, its widened from 10.5 per cent in January to 11 per cent today.
Source: Investment Trust Intelligence
Surprisingly, the average discount is also wider today than in it was in August 2015, when China’s surprise currency devaluation sparked one of the worst single day market corrections since the global financial crisis.
The figures are even more stark when you drill down into individual trusts. As of the 4 October, 22 out of the 25 trusts across the two sectors are trading on wider discounts than their three-year average.
While performance is key to that discount widening, this trend also suggests that while US investors (as shown by positive ETF flows) are becoming increasingly bullish on emerging markets, UK investors – the primary buyers of UK-listed emerging market trusts - aren’t convinced this rally has legs as share prices haven’t kept up with NAV growth.
A good opportunity to add to your exposure?
It’s quite easy to see why UK investors are still generally cautious on emerging markets as most of the headwinds that plagued the developing world haven’t disappeared and the US election is not helping.
However, emerging market equities have underperformed developed markets for a prolonged period of time and valuations remain cheap in relative terms.
So, while predicting the future of emerging market returns is very difficult indeed, recent dynamics mean investors have been presented with a rare opportunity.
On the one hand, if the bears are right and this rally is completely false, trusts such as Pacific Assets – which has one of the best track records of protecting capital and outperforming in both the closed- and open-ended universes during the recent painful period for emerging markets – has seen its discount widen to 5.7 per cent, which is twice as wide as its three-year average.
On the other hand, if the bulls are right and fears over China are overblown, potential rate hikes have already been priced in and emerging market positive earnings forecasts prove to be correct, trust such as Templeton Emerging Markets – which has historically outperformed during more positive market conditions due to its large-cap style (such as this year with NAV growth of 50) – has seen its discount widened to more than 13 per cent.
That figure is, paradoxically, wider than its five-year average discount of 8.5 per cent.
As such, we believe investors can position their portfolios for either a bullish or bearish outcome at an attractive entry point as discounts have widened across the board. The difficult decision is, of course, deciding on which outcome is more likely.
Alex Paget is a research analyst at Kepler Partners, whose work features in Investment Trust Intelligence. The views expressed are his own and should not be taken as investment advice.