October 13, 2011 1:57 pm

Opportunities remain in emerging markets

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Investors have been pulling large sums out of emerging market equity and bond funds in recent months in favour of safer asset classes amid the current global volatility – but advisers believe attractive opportunities are emerging once again in the sector.

Outflows from emerging market equities have hit $39.6bn so far this year – representing 35 per cent of the total flows into the region in 2010, a year which saw huge inflows as investors increasingly abandoned western markets.

In the week to October 7, emerging market equity funds saw redemptions of $3.3bn, the 10th consecutive weekly outflow, according to EPFR Global, a fund flow data provider.

While fixed income funds fared better earlier this year thanks to their high yields at a time when investors have been desperate for income, they have also started to experience significant withdrawals as a result of the turmoil in the global markets. The last week of September saw redemptions of $3.2bn, the biggest outflow since EPFR’s records began in 2004.

In 2009, emerging markets funds rose 57.2 per cent on average, and a further 23.3 per cent the following year. However, in the year to date, returns have fallen by 20.7 per cent, according to Patrick Connolly of AWD Chase de Vere, the financial advisers.

Fixed income funds are also having a more difficult year. The Investec Emerging Markets Local Currency Debt fund, one of the biggest and most popular funds in the sector, returned 58.6 per cent over the past three years but has returned a negative 3.9 per cent over the past year.

“Fund inflows into emerging market equities and debt during 2010 and 2011 are yet another example of investors jumping into asset classes after they have already performed well and then seeing that performance go into reverse,” says Connolly.

In spite of the current economic uncertainty around the eurozone debt crisis, emerging market equities underperformed their developed market counterparts in the third quarter, falling by 23 per cent as measured by the MSCI Emerging Markets index, compared to 17 per cent in developed markets, as measured by the MSCI World index.

Willem Sels, UK head of investment strategy at HSBC Private Bank, believes emerging market assets are likely to continue to suffer in the current market volatility due to their “high beta” character.

“This means that their equity markets and currencies typically move more violently up and down than markets in the west, even though many of the problems of the current crisis originate in the west,” he explains.

Sels notes that, in the current environment, investors do not distinguish much between markets on the basis of fundamentals but trade up and down as a function of overall risk appetite. “When risk appetite is poor, as it may continue to be, most riskier assets may sell off, whether they are in the west or in emerging markets.”

But some experts argue that the recent sell-off in emerging markets has created attractive opportunities for retail investors.

Advocates of emerging market debt say investors can benefit from attractive yields, currently around 5 per cent, and the potential for currency appreciation. “Yields will be more attractive than they are in the west,” explains Adrian Lowcock of Bestinvest, the financial advisers. “It’s more of an income- generation story and currency appreciation.”

Equities or bonds?

Equities: First State Asia Pacific Leaders fund

Launched in 2003, this fund aims to achieve long-term capital growth through investing in large and mid-cap equities in the Asia Pacific region, excluding Japan.

Managed by Angus Tulloch and Alistair Thompson, the £6bn equity fund has returned a negative 0.4 per cent over the past year, but has returned 99.9 per cent over the last five years, according to figures from Trustnet.

It currently has 35.5 per cent invested in the Greater China region, and 20.9 per cent invested in South-East Asia. Its biggest sector weighting is financials at 25.3 per cent, followed by 16.1 per cent in information technology.

Bonds: Investec Emerging Markets Debt fund

This £1.8bn fund was launched in 2007 and invests in local currency debt. The fund aims to achieve long-term total returns primarily through investment in public sector, sovereign and corporate bonds issued by emerging market borrowers.

Managed by Peter Eerdmans, the fund returned a negative 3.9 per cent over the past year, but returned a positive 58.6 per cent over the last three years, according to Trustnet.

However, investors seeking growth are better off investing in emerging market equity funds, experts argue, which can capitalise on the growing domestic middle class consumer population.

Tom Becket, chief investment officer at PSigma Investment Management, believes greater opportunities lie in emerging market equities than fixed income.

“Emerging equities are cheap and there is obviously a chance that they’ll get cheaper given the real lack of sentiment towards any risk asset at the moment,” he explains. “I think on a medium to long term view emerging market equities are approaching valuation levels which could potentially lead to some of the attractive return characteristics we’ve seen from previous low in emerging market equities.”

Bill O’Neill, chief investment officer for Europe, Middle East and Africa at Merrill Lynch Wealth Management, agrees. “The corollary to the recent falls in emerging market equities is that valuations begin to look attractive. The MSCI Emerging Market Index is trading (as at end September) on an 8.8x one year forward price/earnings ratio, nearly 20 per cent below its average since 2002.”

Becket recommends investing in well known fund managers such as First State Asia Pacific fund alongside some more boutique satellite funds such as Findlay Park Latin American fund and Somerset Capital Emerging Market Dividend fund.

He argues that emerging market bond funds, which invest in debt issued by emerging countries, have become an “overly loved asset class”. “I think people are probably giving emerging market governments too much credence in their ability to manage their way through potential financial crises,” says Becket. “I would still much rather invest with high quality emerging market companies and their management than with the politicians of certain emerging market countries.”

Connolly agrees. “We have always been concerned that emerging market debt has been overhyped, with advocates claiming it offers strong performance, high yields and low risk,” he says. He points out that emerging market debt does not provide the same level of security as traditional fixed interest holdings such as gilts or investment grade corporate bonds.

Lowcock says investors that buy exposure to emerging markets through debt funds are really buying exposure to emerging market currencies. “You are not going to tap into the growth of the economies in that region by opting for a debt fund, you are mainly tapping into the appreciation of the currency,” he explains.

He recommends the Investec Emerging Markets Local Currency Debt fund, which currently has a net running yield of 5.1 per cent. “Performance over the past year is down 4 per cent which reflects the fact that the sector probably got ahead of itself,” says Lowcock.

While Beckett prefers emerging market equities, he says that certain elements of emerging markets fixed income should be in a client’s portfolio. He likes the Aberdeen Asian Local Currency Short Duration Bond fund and Stratton Street Capital’s Wealthy Nations Bond fund.

HSBC’s Sels believes that markets may grow more comfortable with emerging market bonds somewhat sooner than with emerging market shares. “Debt markets may benefit from the expectation that inflation may soon start to peak around the world, which could allow emerging market central banks to stop hiking interest rates, benefiting bond prices. We also believe that most emerging market countries continue to be on a more positive credit rating path than governments in the west, which should help valuations as well.”

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