August 15, 2014 7:03 pm

Refining exposure to emerging markets

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More diversity in China, and new positions in Latin America

Earlier this year I increased the notional fund’s investments in emerging markets. After a couple of years of underperformance, they seemed cheap. So far that has gone well; there is renewed interest in India, China and even in parts of Latin America, despite Argentina’s flirtation with another bankruptcy.

This doesn’t mean I’m giving up on the US, despite very strong gains there in this bull market. The US is still leading the advanced world’s recovery from the great slump of 2008/9, and it leads the internet revolution and the shale rush too.

The combination of cheap energy, great technology and an ability to form large multinationals out of the latest digital fashions is a winning combination. The Federal Reserve is still focused on promoting recovery and US banks are in better shape to finance it.

But I am also ready to repeat that it is still a good idea to look east as well for faster growth from a lower base. Take China, a gently sleeping giant. The relatively new government has wanted to draw attention to problems with the economy they are intent on fixing. They have weeded out some corruption, allowed some fringe financial institutions to pay the price of past excess, got inflation down with tighter money and sought to calm the real estate market.

This has led some to fear a far worse outcome than the one we are actually witnessing. The latest service sector advance indicators are a bit disappointing, reflecting the action the government has taken to avoid more overheating in property. The aim is to settle the economy at a little above 7 per cent growth. This will be a good result for the world’s second-largest economy, and should be sufficient to avoid high unemployment and social unrest.

In India, Mr Modi now needs to show his mettle running a business-friendly government, having carried stock markets with him on his rise to power. Brazil has not received the great economic boost out of the football world cup it hoped for, but maybe we have now seen the worse of interest rate rises and the bad news of a slowing economy. Elections in the autumn could bring political change and will certainly cause the present government to focus on policies for economic improvement.

All this has set me thinking about the detail of the fund’s exposure to the emerging world, in particular the indices that the fund is tracking. The Chinese holding is entirely in the FTSE Xinhua China 25 index, which gives exposure to an index of large parastatal Chinese companies whose shares trade in Hong Kong (so-called “red chips” and “H shares”). These have done well in recent months, but this index is heavily concentrated in banks and financials (almost half the value) with telecoms as the next largest sector.

As the international investing community becomes interested in China again I would like to have some exposure to smaller companies and a better balance of sectors. So I am switching part of the holding into SPDR MSCI Emerging Markets Small Cap UCITS ETF. This does dilute the exposure to China by adding Taiwan, South Korea and other emerging economies. But it also diversifies the sectors: Information technology is the lead area in that index at 18 per cent; financials are 17 per cent. The ETF offers a dividend yield of 2.6 per cent, which is attractive from an asset which should have good growth prospects. The multiple of share price to earnings is a modest 13 times; in normal times, one would expect the multiples on smaller companies with better growth prospects to be higher than the market averages.

The fund owns other Asian assets through holdings in iShares Asia Select dividend and BlackRock’s Pacific ex Japan. These give it high exposure to Australia, additional exposure to Hong Kong and China, and some exposure to South Korea, Taiwan and Singapore. Both have been performing well. The higher yields in Australia have been attractive and reflect the scope for prices to catch up with the west a bit. The iShares Core MSCI Emerging Markets ETF adds exposure to South Africa, Brazil, India and Mexico and comes with low running costs.

I am going to add a small position in Latin America by buying a specialist Latin America ETF in the run-up to the Brazilian election. I will finance it by slightly reducing the position in the FTSE 100 after a good run. There should be a resolution of the Argentine debt issue later this year, and there are signs that the Brazilian authorities have now reached the peak of their tightening cycle to get inflation under control.

Investors have to take more risk to try to get any kind of real return, hunting around the rest of the world for more value, knowing all the time that doing so means more risk

- John Redwood

The product I’ll use is HSBC’s MSCI EM Latin American UCITS. This gives 57 per cent exposure to Brazil and 26 per cent to Mexico, the two largest Latin American economies. It’s available in a sterling share class, uses physical replication and charges 0.6 per cent a year.

Latin America is risky, of course. But these are difficult times for investors. Deposit rates and yields on bonds remain very low in the developed world. Stock markets have risen strongly, often before the earnings and growth have come through fully to justify those moves. There are no signs yet that the authorities want to end the party, but there must be limits to how much you want to pay for western shares.

That means investors have to take more risk to try to get any kind of real return, hunting around the rest of the world for more value, knowing all the time that doing so means more risk. If you can find faster growing smaller companies at attractive prices, that can provide some additional hope within a balanced portfolio.

John Redwood chairs the investment committee at Charles Stanley Pan Asset. The contents of this article are for general information only and do not constitute investment advice

See a breakdown of assets in John Redwood’s notional fund at www.ft.com/personal-finance/john-redwood

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