BC: The debt crisis in the United States and parts of Europe has investors seeking investment opportunities in emerging markets, but there is concern that they could be going in with too great an expectation of reward.
In particular, investors are turning their attention to the BRIC economies of Brazil, Russia, India and China in the hope they will still be able to perform despite the situation in other markets.
Is this a fair expectation?
Experts warn in the short-term emerging markets may not be able to provide investors with the comfort they are looking for.
Further, there is a real risk investors will actually view emerging markets as less risky than perhaps what they are because of the prevailing turmoil in other more developed world markets.
"There is a risk of that. Some people are trying to bend the argument that risk is lower in emerging markets than in the developed markets," Lazard Asset Management managing director and portfolio manager James Donald says.
The fundamentals in emerging markets, such as economic growth and income per capital, do look good, but fund managers warn investors still need to watch out for risk. They say investors cannot ignore this, especially when history shows how dangerous such an oversight can be.
"In 2008, the fundamentals were strong but emerging markets had a larger downward move than the developed markets," Donald says.
A label not everyone is sold on
The BRIC markets are regarded as huge growth opportunities because of their populations and resources.
While this cluster of countries has much in common in terms of growth characteristics, the idea of whether pooling them together is an effective investment strategy is a point of debate, even for those working in the emerging markets space.
"It is an interesting concept but it is not helpful to investors in terms of where the opportunities lie," Aberdeen Asset Management portfolio manager Stuart James says.
James says he would prefer it if these countries were known as developing markets. This is consistent with Aberdeen's approach to emerging markets. It prefers to avoid labels and to focus on the companies it invests in rather than the countries.
"The label to us is less important," James says.
He says Argentine seamless pipe-making company Tenaris is a case in point. Eighteen months ago, this company was reclassified by the MSCI as an Italian company.
So it moved from being a company from a developing country to one which is now from a developed company. While its geographical status may have changed, James says this does not change the fundamentals of the company.
Lazard Asset Management does not have a large BRIC strategy, but Donald says it has incubated a strategy in the past.
He says within emerging markets, BRICs are a higher volatility element. "They are quite sensitive to commodity prices and tend to be a more volatile part of the asset class," he says.
Principal Global Investors has sizeable emerging market funds and is a bottom-up stock picker. Fidelity has specific India and China funds.
Buyer beware
Emerging market fund managers report over the past few years inflows have been net positive. This is quite a feat considering investors' prevailing appetite for low-risk investments.
According to Principal Global Investors global economist Bob Baur, it is unsurprising emerging markets have potentially been attractive to a wider group of investors.
"Investors have been putting their hopes on them. And in the last six months it has not been a profitable move," Baur says.
Over this time, most of the BRIC economies have slowed. Baur says while Russia experiences negative growth, Brazil has dropped from 5 per cent to 7 per cent growth to 3 per cent to 4 per cent. China has slowed from 11 per cent to 12 per cent growth to 8 per cent to 9 per cent. Meanwhile, India's growth is somewhat immune.
Baur says the BRIC markets have also all raised their interest rates and the reserves they require to combat inflation. Further, in terms of performance, international equities have outperformed the MSCI Emerging Markets Index.
The outlook is expected to be a bumpy ride for emerging markets as they too will feel the impact of volatility in the more developed markets.
British national daily newspaper The Guardian earlier this month reported that the head of global emerging market equities at First State, Jonathon Asante, had taken the bold move of writing to all investors warning them that he now regarded most stocks in emerging markets as "fully valued".
"He says that so much money has flooded into the shares of emerging market companies that even the best of them may now be overvalued," wrote Patrick Collinson.
Asante reportedly said this was happening in countries where corruption was rife, inflation was rising, legal systems were immature and "back-door state control is common".
Other emerging markets fund managers do not share this view and argue emerging markets are much more resilient in times of volatility because they have domestic demand rather than exports to drive their economies.
Either way, there is expected to be short-term volatility and with that will come investor redemptions.
"I think there is going to be continued volatility in world markets across the board as markets continue to focus on the stuttering economic recovery and the associated political action and or inaction," James says.
This means in the short term outflows from emerging markets are expected to rise.
"I would therefore not be surprised if we see investors selling down their emerging markets exposure, which they perceive to be riskier," James says.
Certainly there is a much brighter longer-term story to emerging markets and those investors who can keep the faith should be able to capture the upside and ride the wave of growth.
"Ultimately emerging markets are at a fraction of their potential," Fidelity investment commentator Michael Collins says.
"They represent 15 to 20 per cent of the world market, they have 90 per cent of the world's oil reserves, with 70 per cent of the world forex resources."
Reasons to sell
Currently a lot of cash is sitting on the sidelines and investors are looking for opportunities.
With this in mind, could investors look more favourably to emerging markets as a viable investment option ahead of the more troubled developed markets?
"Certainly it could happen. This is the part of the world that's growing; western countries aren't in control any more. For them it's more about averting disasters," Collins says.
But there are two trends at play here. History has shown investors do become risk averse in volatile markets and certainly in 2008 emerging market holdings demonstrated this trend.
"In 2008, emerging markets was sold off more heavily than developed, despite the latter being the epicentre of the financial woes," James says.
So the likelihood of them wanting to move out is high. Another issue for investors to possibly overcome is diversification.
Investors may have trouble believing in the benefits of diversification when many had diversified portfolios prior to the global financial crisis (GFC), and this did not seem to do their portfolios a whole lot of favours.
Despite this, experts continue to advocate such an approach. "We certainly think investors ought to be diversified. Many of them have a home bias," Baur says.
And as history shows, only US Treasuries and gold were the only investments that did not go down in value during the GFC, so the performance of emerging markets was relative to what was happening in the wider world.
Role to play in portfolios
Given their higher volatility play, it comes as no surprise that experts say emerging market funds have a place for higher risk-embracing investors.
"However, we find different constituents looking to invest in emerging markets for varying reasons," Donald says.
"Some want the low downside capture and others look for growth. There are also quite a lot of new investors to this asset class who in the past were not prepared."
This is a trend emerging market fund managers are reporting. That is, a preparedness for investors to be a bit contrarian and to perhaps dip their toe in the water.
"They should definitely consider emerging markets, but on a case-by-case basis," James says.
He encourages investors and advisers to "turn down the noise" and to remember it is companies that drive portfolio performance, not countries. Dollar cost averaging into a fund is a good way to capture the current inexpensiveness of stocks rather than putting all your money in.
For Donald, diversification is a key feature provided by emerging markets.
"Perhaps this is less true for someone in Australia than in the US or Europe, but it is still relevant. It also gives you different valuations and a larger universe," he says.
"It [emerging markets] is currently very much the engine of growth in the global economy. I believe China is the most important economy in the world and has been for the last decade because of the industrial revolution going on there."
But there are also a number of other reasons emerging markets are attractive. The stronger growth, lower debt and increasingly attractive valuations of emerging markets should see them gain more attention.
"[There should be more attention] particularly into more domestic or regionally-focused companies," James says.
Donald says: "BRIC has a decent investment case. They are not highly correlated and I feel as long as you have the choice of other securities, they are most useful in a more diversified emerging markets portfolio."
The medium to long-term outlook for emerging markets is strong. Currently emerging markets have single-digit price-earnings ratios, so they look cheap. There is concern over inflation, but as commodity prices should soften, inflation should moderate.
Emerging markets are even regarded as having a greater range of economic tools on hand to help manage volatility and conduct economic management.
"In the West they are running out of options. Once interest rates are 0 per cent, they are running out of options," James says.
And certainly the emerging markets story is a long-term one. As James says, the opportunity for emerging markets to produce goods for the local consumer rather than for exporting remains relatively untapped.
China and India carry the load
Many hopes (and investor dollars) are riding on the China/India story and certainly given the magnitude of these economies, it seems implausible this story could ever end.
So how much longer will China and India remain part of the BRIC economies?
"The outlook for China and India is still solid. They have their challenges, like trying to lower inflation to keep growing. but it does not seem like anything is going to derail it," Collins says.
"The emerging markets story is about rising consumption and past growth has created the ingredients for future growth. People have been pulled out of poverty."
Fidelity investment director Tom Stevenson says there are many factors at play behind the future growth of emerging market economies, particularly in the case of domestic consumption.
"A combination of income growth and social reform will be a particularly potent set of catalysts for Chinese and Asian domestic consumption over the next few decades," Stevenson says.
This is also the case in India where a recent McKinsey report demonstrates how socioeconomic change will translate to an increase in domestic spending.
"McKinsey has forecast that a combination of poverty reduction and favourable demographics will see the Indian middle class grow from 5 per cent of the overall population currently to 41 per cent by only 2025," Stevenson says.
As this occurs, Indian spending habits are expected to shift significantly away from small traders in public markets to more organised retail spending in shopping malls.
Urbanisation will also be a significant engine for growth for both countries. Baur says with only 49.7 per cent of China's population currently urbanised, it should take 20 years or more to reach 80 per cent of the population.
But while the income per capita numbers for China and India are impressive, they are coming off low bases and they are still relatively low. It is fair to say then that both countries have some significant challenges ahead.
"India is quite a difficult market to invest in. Lazard Asset Management has some clients who requested permission years ago and they are still waiting. It will be a long time before India leaves the [MSCI] Emerging Markets Index," Donald says.
And for China, its currency issues remain an obstacle to investment.
"As for China, it's now a wealthier economy. However, while Hong Kong is a fairly sophisticated market, China also has the A and B share markets. I think the index providers won't consider China for an upgrade until there is one uniform market," Donald says.
New BRICs coming through
The MSCI Emerging Markets Index, the main index used by emerging market funds, is very slow to change, so it is not often new emerging markets are included in it.
"The MSCI is now skewed to sophistication and ease of investment. The question they are asking is: "Is there anything special you have to do to invest?" Donald says.
Most recently Taiwan and South Korea were put forward as prospective inclusions in the index, however, issues such as the overhang of government ownership held the countries back from being included.
"In Taiwan, you have to change currency a day in advance. That's the reason we think MSCI didn't upgrade them to developed market status," Donald says.
Meanwhile last year, Israel was promoted while Argentina was demoted. "It is quite an ambiguous area," James says.
To be included in one of the emerging markets indices requires an international market to be easy to invest in and to have convertible currencies.
But indices aside, there are a number of markets that are growing and which have caught the eye of economists and investors looking for new horizons.
Indonesia is growing very fast and Baur says in terms of demographics and growth, it is quite similar to China, India and Brazil and dissimilar to Russia.
"Russia is an aging society built on selling energy at high prices," he says.
He says long-term, emerging markets are certainly where the growth is and he regards the four Asian tigers of Hong Kong, Singapore, South Korea and Taiwan as well as Japan as definite opportunity spots.
"South Korea for the past 40 years has had growth of 8.4 per cent compounded annually. It's just outstanding," he says.
Stevenson notes the potential in Africa, where between 2000 to 2009, 11 countries grew at an annual rate of 7 per cent or more.
"Admittedly, this growth is coming from a low base relative to the rest of the world, but it is also creating some interesting investment opportunities," he says.
He says one of the real standouts is Nigeria. "Nestle and Unilever both have operations in the market as rising incomes allow Nigerian consumers to trade up to more expensive food, beverage and beer products," he says.
Other emerging market opportunities he regards as a layer down from the BRIC markets are Turkey, Indonesia, Mexico and the Philippines. «
