Many open-ended emerging market funds have outperformed trusts year-to-date because they are either purposefully tracking the index or are closet trackers, according to Kepler Partners’ Alex Paget.
The research analyst points out that passive funds in the emerging market space have generally outperformed their active counterparts so far in 2016 and argues that the top-performers in the sector have closely followed the behaviour of their benchmarks.
Performance of index vs sector in 2016
Source: FE Analytics
In the article published this morning, he also said many emerging market trusts are trading on attractive discounts and are underperforming their open-ended counterparts, which means they are well-suited to investors still looking to gain exposure to the rallying sector.
With the MSCI Emerging Market index outperforming other major indices year-to-date after a five-year bout of torrid returns, Paget gives FE Trustnet three emerging market trust picks for a variety of potential outcomes in the sector.
Templeton Emerging Markets – if the rally is the real deal
Paget (pictured) says that Carlos Hardenberg’s Templeton Emerging Markets trust is a good option for investors expecting the emerging market rally to continue. 
“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, trusts like Templeton Emerging Markets also look very attractive at current levels,” he said.
“Its large-cap value style meant the trust struggled during the turbulent years for emerging markets (it lost 35.5 per cent between 2011 and 2015), but we think it can continue to take full advantage of a bull market.”
Year-to-date, the £1.8bn trust has outperformed its benchmark by more than 10 percentage points with a total return of 49.96 per cent, which Paget attributes to changes the manager made after he took over from Dr Mark Mobius in October last year.
Performance of trust vs sector and benchmark in 2016
Source: FE Analytics
Given the portfolio’s value tilt though - a trait that has remained the same under both Mobius and Hardenberg’s tenure - it tends to underperform during falling markets, meaning it has a bottom-decile downside risk ratio (which predicts a fund’s likelihood to fall during negative market conditions) and maximum drawdown (which shows the most potential money lost if bought and sold at the worst possible times) over the last 10 years.
“[Hardenberg] has rotated the portfolio towards higher quality names which should the mean the trust will protect capital more effectively in down markets than it has in the recent past,” Paget continued.
“However, despite those gains and changes made by the manager, Templeton Emerging Markets’ discount has widened to more than 14 per cent (which is paradoxically wider than its five-year average discount of 8.5 per cent).”
Templeton Emerging Markets isn’t geared currently, yields 1.4 per cent and has an ongoing charge of 1.21 per cent.
Pacific Assets – if the rally is fake
Next up is FE Alpha Manager David Gait and Sashi Reddy’s Pacific Assets trust, which has five FE crowns and is £282.1m in size.
While it is benchmarked against the MSCI All Country Asia ex Japan index, it offers investors emerging market exposure through its significant 35.6 per cent India weighting and 18.2 per cent position in Taiwan, as well as moderate weightings in Hong Kong, Bangladesh and the Philippines. While its benchmark has a 31.3 per cent weighting in China, the trust has a 2.8 per cent exposure to the country.
“If the bears are right, and recent actions from the Chinese authorities to maintain economic growth prove illusory, or rate hikes from the Fed put pressure on those economies and corporations with high levels of dollar-denominated debt, we think Pacific Assets is an interesting option,” Paget said.
“The trust has been one of the best performers in its sector over recent years thanks to its focus on high quality, non-cyclical companies with reliable earnings.”
The research analyst points out that the trust tends to lag during bull markets and this year is no exception, given that it has returned 32.09 per cent year-to-date compared to its benchmark’s return of 34.29 per cent and its sector average’s return of 33.94 per cent.
However, it has achieved the highest total returns in its sector over five years and the second-highest returns over three years, given that it has more than doubled the returns of its average peer in 2014 and 2015. During 2013, it outperformed both its benchmark and sector average more than 10 times over with an annualised return of 14. 22 per cent.
Performance of trust vs sector and benchmark over 5yrs
Source: FE Analytics
“Its poor relative performance this year, though, had left the trust trading on a 6 per cent discount to NAV last week, which is twice as wide as its three-year average and far too wide in our opinion,” Paget said.
This discount has now further widened to 10.4 per cent. Pacific Assets isn’t currently geared and has an ongoing charge of 1.02 per cent.
BlackRock Frontiers – for those who want to avoid ETF flow volatility
The final trust pick from Paget is BlackRock Frontiers, which is also five crown-rated and headed up by Sam Vecht and Emily Fletcher.
The research analyst says the trust is an interesting option for those who want to avoid the influence of ETF-driven markets but are still looking for high-growth, emerging market style performance.
While it invests in higher-risk regions than many of its peers in the emerging market space – the trust currently has its largest regional weightings in Argentina, Pakistan and Romania – it has still managed to achieve a top-quartile annualised volatility, maximum drawdown and Sharpe ratio (which measures risk-adjusted returns) over three and five years.
When it comes to returns, it is in the top decile over five years and in the top quartile over three. Since Vecht launched the fund in 2010, it has outperformed its benchmark and sector average by 17.5 and 36.99 percentage points respectively with a total return of 51.32 per cent.
Performance of trust vs sector and benchmark since launch
Source: FE Analytics
“The trust, thanks to its focus on economies that aren’t yet large enough to feature in the MSCI Emerging Markets index, offers exposure to strongly growing areas of the world but is not subject to the same drivers as more mainstream emerging markets portfolios - as ETF money largely cannot yet reach the stocks it holds due to liquidity factors,” Paget explained.
“As such, its holdings are unlikely to be whipsawed by changing sentiment towards the developing world.”
Given the trust’s lower correlation to the MSCI Emerging Markets index (it is benchmarked against MSCI Frontier Markets), it tends to outperform it during falling markets but has struggled to keep up so far this year, having made 36.45 per cent to-date compared to the index’s return of 39.27 per cent.
However, it has significantly outperformed its benchmark, which has returned 23.02 per cent, year-to-date.
BlackRock Frontiers is 4 per cent geared and has an ongoing charge including a performance fee of 1.6 per cent. It has come down from a premium of 2 per cent over recent months and is currently trading on a 2.4 per cent discount.
“The board is committed to limiting discount volatility via issuing shares on a premium and buying them back at a wide discount,” Paget added.