World View: Avoid the hallowed Bric road

Small can be beautiful in the emerging markets universe. Many investors flocking to the asset class this year have focused on the biggest names when in fact there have been, and will continue to be, better returns to be had away from the beaten track.

Traditionally, investment in emerging markets has focused on bonds, not stocks. But this year, the MSCI Free index is up close to 10 per cent and has outpaced the equivalent debt benchmark for the first time since the late 1990s.

Within equities, however, investors need to be aware that the performance dichotomy between large and small exchanges has been noticeable. Followers of the so-called Bric (Brazil Russia, India, China) theory of big emerging market investing will find their portfolios have lagged behind those who picked mid-sized bourses throughout Asia, Latin America and Europe. These have shown top returns, demonstrating the importance of diversification against the pursuit of size advantages.

In 2005, in spite of average gross domestic product growth for the overall universe projected at 5 per cent and price/earnings ratios often in low double digits, this wider allocation strategy could prove decisive with dramatic divergence expected in individual economic and business conditions.

In Asia, China and Taiwan may be seen as must-haves and are a well-known stalwart for portfolio managers in the region but the two have registered some of the worst results this year. Chinese equities have been hit hard by foreign access limitations and corporate weakness. Portfolio inflows, most of it hot money evading normal channels to bet on currency revaluation, are set to equal direct ones at $60bn this year, according to the International Monetary Fund. But they have moved only marginally into the protected, state-controlled A-share market.

Taiwan anticipates a large MSCI index reweighting in its favour with the removal of inward restrictions but has been hampered by lacklustre semiconductor earnings, bank restructuring obstacles and convertible bond fund problems that have brought state rescue.

India is another disappointment, as doubts linger over reform momentum under a leftwing-influenced coalition led by the accomplished technocrat Manmohan Singh. Bombay has recovered from its earlier record decline, and initial public offerings such as that from software house Tata Consultancy Services have been heavily over-subscribed. But inflation and interest rates are rising, and plans to use $10bn in foreign exchange reserves to support public/ private infrastructure projects have provoked fears of official overreach.

At the opposite end of the size spectrum there is a different picture and the Philippines has been the regional pace-setter. Foreign buyers have poured into blue chips such as Philippine Long Distance Telephone (PLDT) and locals, increasingly wary of holding US Treasuries, have diverted funds pending improvements in tax collection to reduce the chronic budget deficit.

There is also growing confidence in the government's determination to tackle public debt, now exceeding 100 per cent of output.

Indonesia is just behind after a strong rally following the election of the business-friendly Susilo Bambang Yudhoyono who has pledged an anti-corruption platform and an agenda of deregulation and monetary restraint.

In Latin America, Brazil sputtered forward by 8 per cent, a far cry from the 50 per cent-plus rallies seen in the small Andean exchanges of Colombia, Peru and Venezuela. In Brazil, buoyant commodity exports from iron to soya (especially to China) may have tapered, domestic borrowing rates remain steep and profit margins have narrowed on soaring energy costs.

Among the capitalisation leaders, Mexico has jumped 30 per cent, but, outside of a handful of new housing and retail offerings, activity continues to focus on a few stocks simultaneously trading in New York, carrying similar exchange rate conversion risk.

In Europe, Russia and Turkey have experienced only half the upswing of their central European counterparts, who have averaged 40 per cent. Following banking runs and demands on natural resource companies for back taxes, Moscow has reversed the uninterrupted bull run of recent years as overall capital flight from the country is forecast at $10bn.

In Turkey, in spite of rapid growth and an unprecedented fall to near single-digit inflation, a successor IMF agreement has yet to be inked and privatisation efforts have found little interest. The withdrawal of a planned issue by the local unit of Coca-Cola amid market deterioration was an additional blow.

Given this split performance, retail holders of global emerging market funds should be careful of index bias and deliberately commit a portion to less liquid but better performing destinations.

With asset managers forecasting that global volatility will sharpen differences and hit big bourses, a lucrative long-term portfolio may be better built through multiple mini-markets "brick by brick" as opposed to the current big Bric fashion.

The writer is senior partner of Kleiman International Partners