With the ongoing tales of woes in Europe, and the United States and Japanese economies still struggling to gain traction, investors might reasonably ask whether better equity market returns are to be found among the emerging markets.

Emerging markets comprise a broad range of countries with still relatively low per capita incomes and great potential to catch-up to the living standards of the developed world. Some obvious examples are Brazil, Russia, India and China – a sub-set of the emerging markets groups otherwise known as the ‘BRIC’ economies.

Two emerging market ETFs

That said, the broader MSCI emerging markets investment index includes some surprisingly developed economies such as South Korea, Taiwan and Malaysia. For investors wanting exposure to these markets, exchange-traded funds (ETFs), tracking either the BRIC index (ASX:IBK) or the broader MSCI emerging market (ASX: IEM) index, can be easily purchased on the Australian stock exchange.

Note, both ETFs are unhedged, meaning investors take on the currency risk of the markets in which they invest. For example, if emerging market currencies fall against the Aussie dollar, the fall will detract from returns and vice-versa.

High beta

As a group, emerging markets can be considered ‘high beta’ investments in that they displayed strong out-performance during the commodity-inspired equity bull markets between 2003 and 2007, and in the initial stages of the post-GFC rebound in markets from early 2009. The downside is that they also tend to fall more heavily during global equity market corrections as investors flock to ‘safe havens’.

Emerging vs developed

But note also that emerging markets have tended to underperform developed markets since late 2010. A major reason has been the slowdown in relative earnings performance; a pickup in inflation led to policy tightening in many countries, and the more recent reduction in commodity prices has hurt earnings in resource exporting countries such as Brazil and Russia.

A decline in valuations relative to developed markets also detracted from emerging market performance. Valuation wise, the price to forward earnings ratio (Forward P/E) for emerging markets has fallen from a relatively pricey 6% discount to developed markets in late 2010 to a more reasonable 15% discount as at the end of May. The current emerging markets valuation discount appears modestly cheap by the standards of the past few years, but less obviously so when considered over a longer time period.

The PE ratios for both developed and emerging markets now appear relatively cheap by historic standards.

Are there opportunities to choose between different emerging markets? In the main, the major emerging market indices have tended to track each other relatively closely in recent years due to the correlated ‘risk-on, risk-off’ nature of investment trends, and the fact major economies such as China have a large weight in all the indices. Overall, however, global investors still tend to trade emerging markets as a single ‘bloc’.

Outlook for emerging markets

Looking forward, emerging markets have the benefit of not being directly tangled up in the debt crises afflicting Europe and the United States since 2007.

Macro-economic policymaking is becoming more reliable, and economic growth is still to remain considerably stronger than that in the developed world. The latest World Bank Economic Outlook expects developing economies to grow by 5.3% in 2012 and 5.9% next year – compared with growth of only 1.4% and 1.9%, respectively, in the developed world.

Easing commodity prices and slowing export markets have also made it easier for emerging economies to become inflated – which provides scope for an easing in restrictive credit policies over the next year.

That said, if global investors remain risk averse, they may well continue to shy away from ‘high beta’ investments like the emerging markets. Capital inflows into the emerging markets have already slowed sharply over the past year due to fear arising from a European meltdown.

From a longer-term perspective, however, emerging markets look reasonably priced and appear to offer a better return outlook than developed markets. That suggests Australian investors might do well to broaden their horizons beyond the usual developed market offerings when seeking international diversification.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Anyone should, before acting, consider the appropriateness of the information in regards to their objectives, financial situation and needs and, if necessary, seek professional advice.