Asquith, who runs the Somerset Emerging Market Small Cap fund, says investors have been ignoring headwinds derived from the sector's growth, consumption and demographics. While he is still optimistic about the long-term potential of emerging market equities, he says it is unsurprising valuations have been knocked back.
"Explanations for short-term market movements are always subjective, so anything below should be taken with this in mind," he said.
"Leaving aside the question of US Treasuries, most emerging market bonds had got expensive, whilst many emerging market equities had got quite expensive."
"The positives of emerging market growth, consumption and demographics had been focused on and embellished whilst negatives were left in the shadows. The role of debt (consumer and government) in the first two of these positives was under-reported but will probably gain greater prominence as yields rise again."
"Demographics are a double-edged sword: this is especially the case in the age of QE when inflation drives up financial assets (typically owned by old westerners) and the cost of living which weighs heavier on the poorer nations’ youth)."
"The negatives of corruption and mismanagement of the larger emerging economies – and, by extension, state-owned companies – were known but downplayed," Asquith added.
The recent relative underperformance of emerging market equities has been well documented.
Over the past three years, the MSCI Emerging Markets index has returned 6.48 per cent to the MSCI World’s 46.08 per cent. This trend has continued in 2013, and year to date the MSCI Emerging Markets index has lost 2.11 per cent, while the MSCI World has returned more than 20 per cent.
Performance of indices year to date
Source: FE Analytics
Asquith says the major reason for the change in sentiment towards the emerging markets has been the relative lack of economic growth outside of consumer-driven areas.
Poor politics is to blame in many countries, he adds, but over time he says investors should not be overly concerned about this.
"An overvalued consumer sector could have been cycled out of if there had been genuine growth opportunities elsewhere."
"China has perhaps built too much infrastructure but many of the other emerging economies – India, South Africa, and Brazil – have built too little."
"This has exacerbated domestic inflation issues and constricted economic potential at the same time as providing a lacklustre earnings environment for many of the more cyclically sensitive listed corporates."
"Many of the governments have chosen instead to focus their budgets on social welfare schemes (too much inflation leads to the Arab Spring) or themselves through on-going cronyism."
"There are signs in India, China, Brazil and South Africa that the governments have got enough of a shock to start changing their ways – even better, we may see some new governments formed in the next couple of years, pointing in a new direction."
"This change will take a little time, however," he added.
Asquith has managed the £65.2m Somerset Emerging Market Small Cap fund since October 2010 and over that time it has been a top-quartile performer in the IMA Global Emerging Markets sector, despite the fact it has returned just 2.87 per cent.
The fund is also a top-quartile performer over one year, with returns of 15.12 per cent, beating both the MSCI Emerging Markets index and the MSCI Emerging Market Small Cap index in the process.
Performance of fund vs sector and indices over 1yr
Source: FE Analytics
Somerset Emerging Market Small Cap is a concentrated portfolio of just 38 holdings. The manager typically invests in companies that have a market cap of between $200m and $2.5bn.
Asquith’s largest regional weightings are to India, South Africa and Taiwan which make up 9.5 per cent, 9.4 per cent and 8.7 per cent of the portfolio, respectively.
Asquith says he has been taking a more defensive stance within his fund over the last few months.
"We said at the start of the year that a decent rebound in earnings (particularly from the cyclical sectors) or a shift of money from bonds into equities was required to drive markets higher as valuations were not that supportive."
"We were reasonably optimistic but the realities of the opportunity set meant we actually spent most of the first half of the year trimming or selling out of larger, expensive, outperforming stocks."
"The only opportunities we could find were in more illiquid stocks or less favoured countries. This led to us underperforming the small cap index and our small cap peers to an increasing extent as the year wore on, a trend that has somewhat reversed over the past couple of months."
"We must maintain this over the second half to open a meaningful performance gap," he added.
Asquith says that because of his more cautious short-term outlook, he has raised his cash position from 6 per cent up to 9.6 per cent so that he can jump on opportunities from a further de-rating.
"This in itself does little to overall performance but does provide dry powder for when opportunities present themselves. We look forward enthusiastically to this and are drawing up lists of companies we would like to own at certain levels."
"The fact that the overall market is around 15x P/E and that only 3.2 per cent of the universe is in deep-value territory (one of the warning signals that started flashing in February) suggests we may not be there yet but we will remain vigilant for individual opportunities," he added.
Somerset Emerging Market Small Cap was soft-closed in 2011 in order to protect current investors. The portfolio was closed when it reached just over £150m AUM to prevent any issues surrounding liquidity.
Unfortunately for investors who want exposure to emerging market small caps, the five crown-rated Aberdeen Global Emerging Markets Smaller Companies is also soft-closed.
However, investors can gain access to the asset class via JPM Emerging Markets Small Cap and Templeton Emerging Market Smaller Companies, among others.
