JOIN PROBUS TODAY!
AUS: 1300 630 488    NZ: 0800 1477 6287

Emerging market equities

by Ben Power | 20 Mar 2013

The Australian stock market makes up less than three per cent of the world’s equities.

Beyond our shores lie opportunities, particularly in the less developed, fast-growing emerging markets of Asia, Russia and South America.

“As these nations mature and become increasingly affluent, their spending ability will rise and pave the way for rapid growth in consumer demand for healthcare, consumer goods and financial services,” says Stephen Thornber, fund manager of the Threadneedle Global Equity Income Fund.

Emerging markets equities have a reputation for being high risk and high reward; they provide higher returns, but tend to be more volatile than stocks in developed countries.

Over the past five years particularly, emerging markets investors have been on a rollercoaster ride. They slumped hard during the GFC, falling 53 per cent in 2008; they then rallied 79 per cent in 2009, but have underperformed developed economy stock markets since, with another tough year in 2011 and only modest gains in 2012.

That volatility is the major downside of emerging markets. Steven Sweeney, senior investment analyst at Lonsec, says that emerging markets are susceptible to global ‘risk appetite’. Basically, when investors are feeling buoyant and confident, they’re more likely to take a risk on emerging markets; when they’re cautious they take money out of the likes of China and India, and bring it back home where they feel safer.

Rewards

The reward for that volatility, however, is higher returns. The past ten years have seen a wild ride, but emerging markets have still returned 16.56 per cent annually. 

Emerging markets equities also provide diversification and access to the opportunities of rapidly growing economies in countries such as China and India. That growth means they are becoming a bigger part of the globe’s economy.

Michael Collins, an investment commentator with Fidelity Worldwide Investments, notes that emerging markets contain 90 per cent of the world’s oil reserves, 80 per cent of the population, 70 per cent of forex reserves, 50 to 90 per cent oil, gas, copper and gold, 40 per cent of world exports, and 35 per cent of the world’s GDP. So it may be wise for investors to try to gain exposure to emerging equities.

How to break in

Many investors already have exposure to emerging markets without realising it. If they have invested in international funds that are benchmarked to the likes of the MSCI ACWI (All Country World Index), then their fund will be invested in emerging markets stocks.

There are other options, including buying exchange traded funds (ETFs that track indexes), managed funds and buying emerging markets stocks directly, but the latter may not be the best option for most investors. Sweeney points to currency risk and lack of liquidity (the ability to get in and out of stocks easily) as reasons to avoid direct investment. “In some of those markets, broking costs also are pretty high,” he adds.

Weigh it up

There is disagreement over how the risks weigh up against the potential rewards for retirees. Sweeney says professional managers have a chance of what’s dubbed ‘generating alpha’ – being able to generate returns above the index – and Lonsec has ‘highly recommended’ a number of emerging markets funds including Aberdeen Emerging Opportunities and Fidelity Asia.

But Paul Banner, principal financial adviser at Provenance Advice, says that because of historic volatility and a lack of income, he would not expose a retirement portfolio to emerging markets equity.

A less risky way to tap into emerging markets is available: investing in companies that are listed and domiciled in the developed world, but that do a lot of work in emerging markets. An example is YUM brands, a US fast food company capitalising on a rising middle class in emerging markets and their demand for western-style fast food.

“This is a less risky form of emerging markets exposure and I do see merit in a modest inclusion in a retirees’ portfolio,” Banner says.

Thornber says companies such as BMW, Coca Cola and Swatch are enjoying significant sales growth from emerging markets. A major exposure to emerging markets in recent times has been commodities companies, such as BHP Billiton and Rio Tinto, which export to emerging markets.

Stability on the horizon?

Over the next 10 years, emerging markets may become less volatile as big investors such as pension funds allocate more capital to them and help them to mature and stabilise. Institutional investors currently allocate around three to five per cent to emerging markets; Sweeney expects that to increase to up to 10 per cent in the next five to 10 years.

In the meantime, they do remain volatile and, along with a lack of income generation, that probably means retirees should limit exposure. “Emerging markets equities should be a minor allocation of retirees’ global equity allocation,” Sweeney says. The good news is that through western companies operating in emerging markets, most investors already are tapped into their potential upside without full exposure to the risks.