Emerging markets add growth and diversification to portfolios and are trading cheaply against developed markets.
They are also more volatile and less liquid, but not necessarily riskier if risk is understood in terms of a permanent loss of capital rather than higher volatility, according to Matthew Read, senior analyst at Quoted Data.
All three expert we spoke to earlier this week for the first part of this guide (Read, Killik associate portfolio director Andrius Makin and Fidelity International investment director Tom Stevenson) saw the current appeal of emerging markets and suggested cautious investors should allocate 0% to 10% in those regions, ‘balanced’ investors 5% to 10%, and so-called adventurous investors between 7.5% and 20%.
Having discussed why investors may wish to invest in emerging markets (and how much they should own), below we reveal how to build exposure to this very diverse region.
Funds, trusts or trackers?
Read, Makin and Stevenson agreed that the closed-ended structure of investment trusts is advantageous for emerging-market investing.
Liquidity is less of a concern for trust managers, who aren’t forced to sell assets to meet redemptions. This way, “the strategy can take a truly long-term view,” said Makin, which is “important in emerging markets, where investor sentiment can change quickly”.
There are also other advantages that trusts have over funds (that goes beyond emerging markets), including better access to unquoted companies and frontier markets, the ability to short companies, which is difficult to do in an open-ended fund, and the ability to take on debt, as well as the discount mechanism.
“As emerging markets already trade at a discount to their developed counterparts, this means you can benefit from a ‘double-discount’,” said Makin.
Exchange-traded funds and index trackers are also an option, although Stevenson prefers accessing the market via an active manager.
“Given the relative lack of research in emerging markets and the importance of analytical boots on the ground, an active approach is likely to be more effective than a passive one in this space,” he said.
Emerging markets was one asset class where trusts beat funds over the past five years, with a 70 percentage points gap between their returns. However, a small-cap tracker has been the best way to invest in emerging markets since 2020.
Global emerging markets or country specialists?
There is more than one sector for investors to build their emerging markets exposure. Both the Investment Association (IA) and the Association of Investment Companies (AIC) have a broader Global Emerging Markets sector as well as country-specific sectors.
In most instances, there is “a strong case” for building one’s emerging markets exposure around one or two broader emerging markets funds, said Read. But, for those with room in their portfolio, allocations to a broad frontier markets fund or some individual markets such as China, India, or Vietnam, “could also make sense”.
A single-country fund can provide exposure to the less-represented and potentially faster-growing markets, but this needs to be considered relative to the greater risks, Makin noted.
“Investors would also need to consider liquidity and concentration risks: Is there enough companies in the underlying market to actually build a diversified portfolio?”
For those willing to take the risk and go granular, some countries, such as China, offer a variety of sector exposures – exporters, consumer stocks and, increasingly, technological innovation, noted Stevenson; while other markets are more focused.
For example, Korea and Taiwan have a bias towards IT hardware and memory chips, while others in Latin America and South Africa are more focused on commodities.
“There are also big variations in performance in any given period. In the past year, for example, India has fallen while China has soared. In recent years, the reverse has been the case,” he noted. “Timing these moves is difficult, however, so for many investors a broader fund would make more sense.”
Are emerging market bonds worth looking into?
Improvements in emerging markets’ fiscal balances in recent years, as well as the relative strength of some currencies versus developed country currencies such as sterling and the US dollar, have put emerging market debt in the limelight.
Another tailwind for the asset class, Stevenson added, is “the potential for some emerging market central banks to reduce interest rates thanks to the still higher real, inflation-adjusted interest rates”. This is true in places like Brazil, he said.
In the past year, several fixed-income managers have been looking at emerging markets, including Fidelity’s Mike Riddell, who said he has reached the highest weighting in his career to the asset class. A similar view was expressed by Xavier Baraton, global chief investment officer at HSBC Asset Management.
While there are no closed-ended strategies solely dedicated to emerging market debt, 112 open-ended funds are available across three Investment Association sectors – IA Global EM Bonds - Blended, IA Global EM Bonds - Hard Currency and IA Global EM Bonds - Local Currency.