The emerging market outlook – are they worth buying?

Financial journalist
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Emerging markets are a volatile place to invest, but that’s their attraction for many investors. It sounds counter-intuitive, but adding a notoriously volatile asset class to your portfolio can help reduce the portfolio’s overall volatility, while adding to its potential return.

Over the last decade, the sector has been popularised by the BRIC acronym – standing for Brazil, Russia, India and China – coined by Goldman Sachs’ Jim O’Neill in 2003. Those four large emerging markets make up most of the sector’s benchmark, the Morgan Stanley Capital International (MSCI) Emerging Markets Index, and have been the mainstay of the Emerging Markets’ return.

The growth story

The BRIC countries – particularly China – have been strong generators of economic growth. The economies of the four BRIC countries grew at an average annual rate of 6.6% between 2001 and 2010, twice as fast as the global economy and four times the rate of the US.

The BRICs slowed a little to 6.3% growth across 2011 and 2012, but that’s still booming compared to a global economy – held down by struggling Europe and the US – that managed only 2.3% growth in 2012. The World Bank does not even expect that growth rate to be repeated in 2013: it is looking for something less than 2.2%.

While a country’s share market returns and its gross domestic product (GDP) growth do not always match, there are two major attractions of the emerging markets as an investment theme. The first is exposure to the huge growth of new consumers – hundreds of millions of them – that are coming onstream as the emerging markets move up the GDP per capita ladder. The second is an investment that is not strongly correlated to the developed-world markets, particularly the US market. That is where the diversification angle of emerging markets is handy.

Recently, the emerging markets’ growth story has been slammed by the inflation emerging from the western central banks’ quantitative easing (QE): programs, which have now been joined by the ‘QE-on-steroids’ program of the Bank of Japan.

With interest rates and bond yields in the developed markets at historic lows, QE has sent floods of “hot” money into property and shares in the developing nations. Inevitably, that has flowed into food inflation, which has become a problem for governments.

The emerging markets slumped in June, when the MSCI Emerging Markets Index fell by 6.8% in US$ terms, because the US Federal Reserve chairman Ben Bernanke spoke of the Fed preparing to end – or at least “taper” – QE, and end the supply of cheap money. This caused sell-offs in emerging markets stocks, bonds and currencies.

But with Bernanke seemingly back-tracking on this determination in September, the emerging markets have recovered some ground.

Below is a comparison of the MSCI World Index (which covers 23 developed-world countries) with the MSCI Emerging Markets Index (which covers 21 emerging markets) and the MSCI BRIC Index. The developed markets have done best in the recent past: the emerging and BRIC markets have performed best over 10 years.

MSCI Emerging Markets and BRIC Indices versus World Index

How to get access

On the Australian Securities Exchange (ASX), there are eight exchange-traded funds (ETFs) that give investors emerging-market exposure through one listed stock: these are shown in the table below. For example, the iShares MSCI Emerging Markets ETF (ASX code: IEM) tracks the MSCI Emerging Markets Index, while the iShares China Large-Cap ETF (IZZ) tracks the FTSE China 25 Index, which represents the performance of the largest companies in the Chinese stock market that are available to international investors.

The iShares Asia 50 ETF (IAA) tracks an index composed of 50 of the largest Asian stocks from the Hong Kong, Korea, Taiwan and Singapore markets. The iShares MSCI BRIC ETF (IBK) tracks an index of the top Brazilian, Russian, Indian and Chinese stocks, while the other ETFs follow the MSCI indices of the South Korean, Hong Kong, Taiwanese and Singapore stock exchanges.

The ETFs provide a quick, simple way to diversify a portfolio, through one simple trade on the ASX, for normal share brokerage costs, and the investor can put in whatever amount they like. The ETFs cost less than most traditional managed funds and are more transparent, because the portfolio holdings are publicly disclosed as often as daily.

All of the iShares ETFs are unhedged, meaning that investors buying in A$ face currency risk on top of the share market risk they take. This can both augment and detract from the final performance of the investment in A$.

ASX-listed Emerging Markets Exchange-Traded Funds (ETFs)

The more traditional route is to invest in unlisted emerging markets funds, which are usually available both for direct investment and through platforms (on which the advertised minimum investment of wholesale funds can be much lower). As shown in the table below, the best Australian emerging markets funds have been strong performers – most notably, the CFS Wholesale Global Emerging Market Fund and the Aberdeen Emerging Opportunities Fund – but there is a wide range of performance. Most of these funds are unhedged, too.

Top Australian unlisted emerging markets funds (to August 2013)

A broadly diversified exposure like the IEM will suit many investors – for example, it will pick up a high-potential country like Indonesia, but it will also have exposures you might not necessarily want, in Africa, Asia, Europe and Latin America. There is the ability to be more targeted with some of the other ETFs, even down to individual country level.

In the managed funds, you entrust the manager with choosing a portfolio of stocks from emerging markets, rather than simply receiving the index performance that the ETFs give you. This may suit some investors, but make sure that (a) you are happy with the portfolio, and (b) you can get access to the fund cheaply through a platform.

Important: 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. Consider the appropriateness of the information in regards to your circumstances.

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