Investors in emerging markets should embrace volatility rather than fear it, according to BlackRock’s Gordon Fraser, who says it can be “more of a blessing than a threat”.
While developed markets responded to a difficult end to 2018 with a strong rally, emerging markets have struggled to keep up.
Since the start of the year the developed markets-focused MSCI World index has made a total return of 21.66 per cent – in sterling terms – while the MSCI Emerging Markets index is up 14.36 per cent.
This has been accompanied by a rise in volatility, with greater uncertainty thanks to the return of the US-China trade disputes.
Rolling 3-month volatility of indices YTD in US dollar
Source: FE Analytics
Yet FE Alpha Manager Fraser said that it is precisely the volatility of emerging market stocks that make them so attractive.
“The key thing to understand is that emerging markets will always give you opportunities: they’re complex, volatile, and there’s massive dispersion of single-stock returns,” he explained.
Fraser, manager of the five FE Crown-rated BlackRock Emerging Markets fund alongside co-manager Andrew Swan, said emerging markets typically go through a set number of stages, which investors can benefit from if they know what to look for.
“Volatility is your friend, it gives you the opportunity to make excess returns, as I believe emerging markets follow quite a standardised macroeconomic cycle and you can make money out of that by buying into countries when they are early cycle and selling when there are late-cycle properties. And doing that over and over again,” he said.
While Fraser follows a bottom-up process, he said it means nothing without an understanding of the macroeconomic environment.
He explained: “You want to align your stock selection with your macro view because if you get the macro cycle wrong it doesn’t really matter whether you’ve got a good or bad bottom-up process.”
It’s important too, the manager said, to recognise that there is a wide range of different economies within emerging markets and as such there are ways to benefit from the different stages of the cycle.
“What matters is that there are lots of different types of countries in the emerging market universe and they give you different levers to express different views in your portfolio,” he said.
The manager classifies emerging market countries into four key buckets – export-orientated countries, capital importers, commodity-sensitive countries and eurozone-correlated economies. He said they will all behave differently depending on the macroeconomic environment, which means he can use the different boxes to change the tilt of his portfolio.
Fraser is currently finding opportunities in Latin America, where three of the largest economies are at an early stage of the cycle.
“Some of the biggest overweights in the portfolio are in Brazil, Mexico, and Argentina,” he said. “All three of these countries actually had quite a weak macroeconomic backdrop over the last few years and we think these economies are re-accelerating in the coming couple of years.”
Performance of indices in sterling YTD
Source: FE Analytics
He added: “We believe that all three of these Latin American countries are in the early-cycle phase: monetary policy is easing, economic activity will start to turn up and we think corporate profits will therefore start to grow more quickly and equities will do well.”
Where there are early-cycle opportunities, there will also be late-cycle economies worth avoiding, with some currently found in Asia.
For example, he thinks the Korean economy is degenerating or potentially slipping into recession and he sees significant problems in the housing and labour markets.
He added: “Probably the most interesting opportunity right now is the Philippines. But the country has been going through the ringer over the past couple of years. We believe it’s passed through the worst of that.
“The central bank will embrace [Philippines president Rodrigo] Duterte’s policies for the coming year and the economy will start to improve.”
Fraser said it is important to have a flexible process in the fund, asking its analysts to disregard style and identify the best ideas from across the emerging markets universe.
“The fund outperformed the benchmark in each of the past three years and the market environments have been very different,” he added.
“I think it speaks to our approach which is to have a flexible style allocation in the fund, and to be largely driven by macro allocations, as well as bottom-up ideas coming from my team.
“2017 was a bull market year led by growth companies, 2018 was a bear market year where value looked better than growth, and 2019 – so far – has again seen positive returns to the market led by growth,” he said. “So, to make money in all the environments, you need to do two things: you need to, first of all, you need to source returns from things that are not just about style.
“Secondly, you need to change your style of the fund to actually try and make money in different environments.”
“We ran a portfolio with growth exposure for much of 2017, we moved that into value in early 2018 and then back into growth towards the end of 2018 to position for this recovery.”
While performance has lagged developed markets this year, Fraser said there are key diversification benefits of emerging markets for investors.
“Most investors under-allocate to emerging markets compared with the benchmark,” he explained. “In general, the time to invest in emerging markets is when growth and currencies are weak, that’s when you typically make the most money.
“If you compare emerging markets to developed markets where a lot of people have capital, emerging markets are considerably cheaper, at least relatively, with economic growth coming in the next three to five years.
He concluded: “So, you have better growth, cheaper valuations, underinvestment, and, cyclically, you’re at an attractive point to be allocating capital. These are reasons for people to consider putting money to work in emerging markets.”
Performance of fund vs sector & benchmark under Fraser
Source: FE Analytics
Under Fraser, the £253.4m BlackRock Emerging Markets fund has made a total return of 28 per cent compared with a 15.04 per cent gain for the MSCI Emerging Markets benchmark and a 14.62 per cent return for its average IA Global Emerging Markets peer. The fund has an ongoing charges figure (OCF) of 1.01 per cent.