Australian investors have traditionally shied away from emerging market investment opportunities because developed country markets offered very similar returns to growth markets.
But as emerging markets continue to pick up speed, investors still seem to be wary about the prospect of investing in an 'undeveloped' economy.
Driven by the slowdown in markets and the United States, and boosted by fund growth in domestic emerging economies, these markets now offer huge potential for investment, and will only continue going from strength to strength.
Asia is top dog
China seems to be comfortably sitting at the top of emerging market funds (see table), closely followed by Brazil and South Korea.
Goldman Sachs Asset Management (GSAM) predicts these growth markets, and those such as India and Russia, will drive around 60 per cent of global growth in the next decade, contributing more than the US and eurozone combined.
"This takes [emerging/growth markets] from being very niche or optional, which clients used to thing of it as, to actually needing to be a very core part of client portfolios," GSAM senior portfolio strategist Kathryn Koch tells ifa.
Anticipated growth in these markets is supported by the trend for a developed world slowdown, particularly in western economies.
Principal Global Investors chief executive Grant Forster explains that the past few years has also seen the rise of intra-emerging market trade.
For example, China is the largest net importer of soy beans, while Brazil is a huge supplier, Forster says.
"Those sort of dependencies 15 to 20 years ago didn't exist. It's a good thing because it insulates some of the emerging markets from the impact of significant slowdown in western growth," he says.
But other Asian markets are also expected to have strong consumption growth in the next decade, particularly Indonesia and the Philippines.
Indonesia's economy is currently benefiting from significant economic reforms undertaken by the government, Threadneedle Investments Asia and global emerging market equities fund manager Rafael Polatinsky tells ifa.
"Wages have risen on the back of strong productivity gains, growth in domestic corporate profitability, high commodity prices and agricultural prices, and given the huge population of over 200 million, the potential for growth is significant," Polatinsky says.
"Another market we like is the Philippines, where the government has also made significant progress in implementing macroeconomic reforms, debt levels have fallen and, much like Indonesia, is reaping the benefits of the reforms."
Colonial First State Global Asset Management investment markets research senior analyst James White agrees Indonesia and the Philippines are performing very well on the back of domestic growth.
"Africa too is seeing strong, structural growth, which is a function of greater regional stability, higher resource prices and a pipeline of investment, particularly from China," White says.
But he explains emerging market strength is relatively uncorrelated to the trends in Australian asset markets.
"While Australia's growth is dependent on economic growth in the emerging world, this doesn't necessarily equate to high correlations across stock markets. For some markets, high commodity prices are a blessing, Russia is a good example, while for other markets high commodity prices are a curse, such as India, where high prices constrain household purchasing power," he says.
India is substantially constrained by its infrastructure, meaning inflation can often play a very important role in its economy. At the moment, India is still dealing with high inflation and so monetary policy is unable to accommodate faster growth, White says.
In addition to taking advantage of emerging market stocks by country, investors also need to consider which sectors are particularly strong against their developed market equivalent.
For example, sectors such as financial services, technology and materials are much stronger in emerging market economies (see pie charts).
Fidelity Investment commentator Michael Collins notes there are more and more stocks appearing in the emerging markets. "Companies in emerging markets are developing global brands or mega brands within their own countries," Collins tells ifa.
He explains the classics are Samsung and Hyundai, which are classed as emerging stocks but are global brands.
"If you look longer term, generally stock markets catch up to where their economy is going. When you are looking at emerging markets, they have 90 per cent of world oil reserves, 80 per cent of the world population and about 70 per cent of global growth," he says.
"They're responsible for about 40 per cent of global exports, but they are only 13 per cent of a MSCI ACWI (All Country World Index). Over time that will increase."
EM exposure essential
A shift from global developed markets to growth markets is likely to be an important investment theme in the next 10 years.
It will no longer be enough for Australian investors to invest in Australia-based companies, or even US or European companies. Participants agree direct exposure to emerging or growth markets is essential.
"We believe that 25 per cent of clients' portfolios both in equity and fixed income should be allocated directly into some of these bigger countries [Brazil, Russia, India and China] that we call the growth markets," Koch says.
"We believe it is actually critical for Australian clients to get direct exposure into the growth markets.
"[Also], right now valuations for these countries are actually incredibly compelling."
Polatinsky agrees that given higher-than-expected growth levels in emerging markets and undemanding valuations, investors should have a portion of their overall equity exposure in emerging markets.
But he explains investors, and their advisers, need to be wary that the markets are high beta and returns are volatile, so investors should be looking to invest over a number of years.
"For those investors with lower risk appetite, a better way of gaining exposure to the strong growth is to invest in Australian stocks with exposure to emerging markets," he says.
For example, companies such as Coca-Cola Amatil and Ansell earn significant revenue from emerging markets, but also benefit from a local management team in developed markets.
"This helps to reduce the corporate governance risk that is prevalent in so many emerging market companies," Polatinsky says.
"Following the falls in emerging markets over the past year and undemanding valuations, advisers should be advising investors to increase their overall equity exposure to emerging markets."
He says that given the risk of continued falls in commodity prices following slowing Chinese infrastructure growth, advisers should also be advising their clients to increase diversification away from Australian dollar investments.
"This could be done by increasing exposure to Australian stocks with exposure to overseas markets [such as emerging markets] or increase allocations to overseas equities," he says.
Advisers need to persuade their clients to take advantage of the attractive growth rates anticipated in the near term for emerging markets, which are unlikely to be seen in the next three years in the developed economy.
"If I was an adviser I would be doing one of two things. I would be ensuring global equity managers were getting exposure to those markets and/or making sure that if I didn't feel like they were or had enough exposure, I would be buying a segregated emerging markets fund," Forster says.
Client education also plays a big role.
"Clients [need to get] out of term deposits, which in some part hasn't been a bad move over the last three to four years versus equities. So whilst in general they haven't been such a bad place to be, people have suffered more recently as a result of staying in term deposits. You've got to get them out of cash and across to emerging markets," Forster says.
White says emerging markets should be a long-term, but small part of a portfolio aimed at capital growth.
"The volatility inherent to these markets, particularly due to political events, makes high allocations risky," he says.
"It is, however, also true that growth in these economies will remain structurally strong compared to low/no-growth environments in the developed economies."
Outlook
Previously, investors have been known to be agnostic about where to invest because developed country markets have given a similar return to growth markets.
However, there is expected to be a marked change going forward as emerging market growth picks up speed.
"We don't think that is going to be the case over the next decade," Koch says.
"We feel very strongly that the growth and emerging markets are set to have better emerging market performances than the Australian equity markets."
She also says she expects the increasing importance of domestic consumption in these markets will aid growth.
"We think the story in growth markets going forward is going to be increasingly about the domestic consumer," she says.
Although in recent months there has been an economic slowdown in a number of emerging economies, such as China, India and Brazil, underlying growth is expected to remain healthy in the next few years, especially relative to the developed world.
"Market valuations are not expensive relative to recent history or compared to developed markets; looking forward, strong consumer demand should underpin economic growth," Polatinsky says.
"Given the relatively low levels of consumer and government debt, and the healthy state of financial sectors compared with those in the developed world, we believe that investors will again refocus on the attractive fundamentals on offer."
Forster explains that while individuals are not necessarily going to become enlightened about the opportunities in emerging markets, advisers will become more risk focused.
"I think global investment managers who have broad mandates will increasingly and have been increasingly allocating to emerging markets," he says.
"So where your global investment manager has that flexibility, they will use it more and more and if they don't use it, markets forces will dictate that they have to in order to keep pace with their peers."
Collins agrees that it will take time to change people's investing habits, especially when it concerns shifting assets in Australian equities offshore.
But he says emerging markets stocks will be a bigger component of global indices over time. So in order to make money by investing, clients need to keep on top of these trends.
"The irony of emerging markets is they are also a risk play. If people get frightened and pile into government bonds, well emerging markets tend to fall more quickly than other stocks. That's because they've got that risk element," he says.
"But over time they'll become less of a risk play and people will judge them more on fundamentals."
