Is there a role for emerging markets funds in the future?

Posted by Fiona Liu in Portfolio management category on 18 Feb 16


Emerging Markets

Is there a role for emerging markets funds in the future?

Love it or hate it – emerging markets have recently hit the spotlight in the world of investments. There has been national coverage with everyone debating on China’s growth and how it might affect the global economy. Other emerging markets will inevitably be affected – as some of these countries have relied on China to import their products. In this blog, we explore what defines an emerging market and what we need to consider when investing in this sector.

Characteristics of an emerging market

China is the world’s second largest economy but it is still a developing country. So how do we classify what an emerging market is? Although there is no set definition of “emerging markets”, it generally tends to describe economies that are experiencing rapid growth. These countries typically have a growing young workforce which should in theory help build new infrastructures that will modernise their country. With the rapid growth the younger workforce brings, there is usually an expansion of the middle class and an increase in spending power to boost its own and the global economy. Along with this, the Government will also implement policies that will make the country politically and economically stable as part of its plan to become a developed economy.

The power of BRICs

Jim O’Neill, the former chief economist for Goldman Sachs created the acronym BRIC in 2001 when he published his paper “Building Better Global Economic BRICs”. It represented Brazil, Russia, India and China and it highlighted that these four countries would experience rapid growth with China taking the lead. He predicted that they would also play an influential role in the global economy. In 2010, South Africa became the 5th member of BRICS. Currently, they make up around 30% of global GDP* with China and India being two of the fastest growing economies in the world.

A comparison of the GDP forecast with US is shown in the table below:

GDP Forecast 2015 2016 2017
Brazil -3.10 -1.20 1.81
Russia -4.04 -0.43 1.65
India 7.21 7.33 7.37
China 6.75 6.54 6.22
South Africa 1.50 1.51 2.00
United States 2.43 2.52 2.39
  Source: OECD (2015), Real GDP forecast (indicator)
 
Commodities (and their prices) are important to the economies of emerging markets e.g. Russia’s economy is predominately driven by oil production. As China has experienced a slowdown in industrial production, its demand for commodity imports has reduced which has put global commodity prices under pressure. On the other hand, there are some countries benefitting from the fall in commodity prices as their economy does not depend on exports of commodities e.g. India is an importer of oil and the cheaper oil prices has helped its economy.

Brazil and Russia are facing a series of hurdles that are damaging their GDP growth – As well as the commodities being priced in US Dollars (USD), their external debts are also priced in this currency. There is uncertainty on how the USD will react when the anticipated interest rate rises happen in the U.S; however a strengthening of the USD against their currencies will no doubt hurt their economy.
As well as this, Brazil is experiencing one of its largest scandals as the alleged corruption at state owned oil company – Petrobras has rallied public protests against the Government. Russia is currently going through a recession and one of the factors is the falling oil price – the economy heavily relies on its energy exports. In 2014, the majority of its oil exports went to Europe. However since September 2014 sanctions have been imposed and this has also contributed to the stalled growth in its economy.

Active or passive approach to emerging market funds

There has been a longstanding debate whether investors should take the active or passive approach when investing in funds. There are pros and cons for both options and we have explored some of them below:

The main advantage of passive funds is the low costs involved in investing in them. It can be a cost effective solution for someone who wants to gain exposure to the emerging markets sector as part of their portfolio. If you are interested in buying an emerging markets passive fund, it might be worthwhile checking which index it is tracking. For example, the L&G Global Emerging Markets index fund tracks the FTSE All World Emerging index; the BlackRock Emerging Markets equity tracker replicates the FTSE Emerging index whereas the iShares Core MSCI Emerging Markets ETF tracks the MSCI Emerging Markets. These indices can have different weighting in countries and sectors which may influence which tracker you would choose.

Compared to the developed economies, the emerging markets sector is under-researched, giving opportunities for fund mangers to pick stocks that will add value to their portfolio. In addition, the majority of the emerging market indices are sector or country bias e.g. the MSCI emerging markets index*** has a 26.6% weighting in China and 28% in the financials sector. With such a bias, if China or the financial sector underperforms, it can heavily damage the returns in a passive fund. Another advantage that fund managers have over passive funds is that they can also seek opportunities in countries or sectors that the index doesn’t include. Considering these factors within emerging markets, there seems to be a stronger case to justify the higher management fees active managers attract.

What else to consider when investing into emerging markets

Although there are around 80 active funds in the IA global emerging market sector, the table below highlights the vast differences in what countries the fund managers will invest in. Therefore, it is worthwhile looking at the factsheets carefully if you don’t want too much exposure to a particular country.

Fund Name Top 3 Counties invested in
BlackRock Emerging Markets       China      
(28.1%)
Taiwan
(12%)
Korea
(10.7%)
JPM Emerging Markets India
(22%)
China
(18.1%)
South Africa
(16.3%)
Neptune Emerging Markets India
(34.3%)
China & Hong Kong
(29.3%)
South Korea
(11.6%)
Stewart Investors Global
Emering Markets Leaders
India
(20.6%)
United Kingdom
(12.9%)
South Africa
(10%)
MSCI Emerging Markets Index China
(26.6%)
South Korea
(15.6%)
Taiwan
(12.1%)
  Fund figures as at November 2015
Index figures as at December 2015
 
You may have also noticed that “United Kingdom” also makes it into the top 3 holdings for an emerging market fund. The reason for this is because typically these fund managers will invest in UK companies that also have a significant exposure to the emerging markets sector. For example, in the case of the Stewart Investors Global Emerging Markets Leaders, it invests 8.5% of the funds into Unilever which is a FTSE 100 listed company but has prominent businesses in emerging markets – it accounts for 57% of their business. This type of strategy arguably can reduce the overall risk in investing in emerging markets – especially when the sector is experiencing a difficult time. However, on the other hand, the performance of these funds may lag when the FTSE falls.

Apart from investing directly into an emerging market fund, there is an option to invest into a fund that has some exposure to developing countries. For example, the Old Mutual Asia Pacific fund** has a 17.8% weighting in China but its largest weighting is in Australia (20.6%). You may want to consider these types of fund if you don’t want full exposure into the emerging markets sector.

How have they performed?

As shown in the graph below (last 10 years performance), emerging markets is a volatile sector to invest in. However, some developing economies are growing at a rate quicker than their developed counterparts. When the 2008 financial crisis occurred, one of the main factors why the emerging market sector recovered quickly was because China was undergoing rapid growth. It has been the world’s largest commodity consumer – using the imported metals to build its infrastructure. It made them a significant contributor to global growth and this suggests that there is potential for other developing countries to do the same. Therefore investing in the emerging markets sector can help diversify your portfolio.

Resolutions

For a country undergoing rapid transformation, there will be setbacks – which is why the emerging markets sector is seen as a “riskier” sector to invest in. Although there are potentials for rewarding returns, investment in this sector should be classified as a long term investment with at least a 10 year outlook.

What’s the future for emerging markets?

Despite the troubles some of the members of BRICs are experiencing, emerging markets are important for the global economy as it is a significant contributor to global growth – in 2015, it accounted for more than 70% of global growth****. Whilst the emerging markets have experienced slowdown in growth for the past few years, it still drives the global economy and it is possible that one day, one of these emerging markets will overtake US to become the largest economy in the world.

*Source: UFA Russia BRICS Summit 2015, GDP: Gross Domestic Product – a statistic that measures economic output
**Figures as at November 2015
***Figures as at December 2015
****Source IMF World Economic Outlook Update January 2016

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact

Tell us what you think

We would love to hear what you think of our Insight area or if you have any questions or suggestions.

Tell us what you think

Media Enquiries

Need to speak with our PR Team?

Contact us

Related content

: explore

Use our Fund and Equity research tool to find investment instruments that meet your criteria.

Take me exploring

: play

Why not take a look at : play which enables you to have a risk-free try at selecting funds?

Find out about : play

: review

Use our review tool to keep a track of the assets that you hold with the Willis Owen agency or elsewhere.

Review my existing assets