Emerging markets, emerging opportunities

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Lonsec recently completed its 2010 review of the Global Emerging Markets and Regional Equities sector following review meetings held in March and April. Duncan Knight, Senior Investment Analyst, recounts some of the key themes and observations from this review.

The Global Emerging Markets (GEMs) and Regional Equities sector now encompasses 20 funds, an expanding universe with six new funds being formally rated by Lonsec. This growth reflects a combination of continued product development for retail investors in this category and a desire to increase product choice in a growth sector for advisers and their clients.
Allocation

Lonsec’s continued belief that GEMs and regional funds can play an important role in a well diversified investment strategy has been further reinforced by the recent sector review. However, just like the sector itself, deciding how much is a responsible allocation to GEMs is not for the faint hearted.

Spoilt for choice

Australian investors looking to gain exposure to emerging markets have no shortage of options. Single country funds, regional funds, emerging markets funds, BRIC funds, emerging markets ETFs, commodity ETFs, and even individual resource stocks to touch on a few.

Indeed some could argue that the Australian stock market behaves like an emerging market, as do global equity funds that have the capacity to invest in emerging markets. Given the Australian stock market is dominated by resource stocks, investors with a significant holding of Australian shares should be aware that they may already have extensive exposure to emerging market themes.
If you consider the characteristics, the Australian market shares its characteristics with many of the larger economies in the MSCI Emerging Markets Index which by their composition are also exposed to the fortunes of commodities – for example, Brazil (16% of the MSCI EM index), South Africa (8%) and Russia (6%).

Performance considerations

Over the long term, emerging markets indices have delivered higher returns than developed global equities, albeit with higher volatility. In looking at the historical performance returns, the temptation could be to dive in with a chunky exposure. However, due to the increased volatility associated with GEMs, it is important to consider your clients’ risk appetite and the likely tenure of any investment.

In a recent market update, Templeton stated that most institutional clients allocate somewhere between 3-8% of their total portfolios to emerging markets. Allocations are further complicated by the crowded trade scenario, the notion that via Australian resource stocks investors are already heavily exposed to China and emerging market-related themes, and investors need to be mindful not to double up exposure to those themes.

Challenges for emerging economies

Emerging markets remain transitional economies, generally growing at growth rates above the global average and are often portrayed as tomorrow‘s advanced economies. Governments in these markets are generally implementing economic reform programs to attract greater levels of foreign direct investment, and in turn promote increased local investment.

There are numerous challenges confronting these booming economies and progress is rarely linear. These governments must strive to absorb the rising capital inflows, reduce reliance on exports while encouraging domestic spending, nurture a stable political and social backdrop enabling the majority of the population to participate in increasing prosperity and seek to avoid a boom-bust scenario. The Chinese government‘s attempts to dampen speculation in the property market are evidence of the challenges facing these economies.

Should an emerging economy reach sufficient progress, it can move towards developed status (as the likes of Singapore and Hong Kong have achieved). Israel is the most recent upwardly mobile economy to make the transition from developing to advanced status. MSCI Barra reclassified the MSCI Israel Index from the MSCI Emerging Markets Index (MSCI EM) to the MSCI World Index in May 2010.
At the same time, the Index guardian deferred Korea‘s promotion, citing the need for progress on the currency, regulatory and perceived anti-competitive practices. Taiwan has also been identified as a candidate for developed market status at the mid-2010 review.

This highlights that the transition from emerging market status is not always smooth sailing but can provide opportunity for astute investor to participate in this growth. Lonsec recognises that the risks associated with emerging market investing are not for everyone, being aware of the potential hurdles that may strike investments is paramount to a well managed investment portfolio for investors.

How to access emerging markets

In terms of positioning, there is no doubt that China—as the largest economy in the MSCI EM index—remains central to the prospects for Asian and emerging market equities. Interestingly, Lonsec did not discern too much hysteria or negativity about China‘s economic prospects among investment managers in this review cycle. Certainly, there were some concerns about rampant property speculation and the impact on the broader economy including the capital strength of Chinese banks. However, the mood on the ground contrasted strongly with much of the obsessive rhetoric of the Australian financial press and commentators sweating on a run on Chinese equity prices and broader economic collapse.

While China is somewhat of a buzzword that has many investors craving a level of exposure, it is worth noting that typically, to date, Lonsec‘s higher rated global emerging market managers tend to be characterised as less benchmark aware in their investment approach and reside over broader mandates in terms of countries in which they can invest. Emerging markets tend to be inefficient (more so than developed) and less heavily researched this allows fundamental, active managers to exploit insights gained from direct company contact and the research effort in general.

Emerging market investors have numerous readily available investment options to obtain market exposure (ETFs covering regions and single countries) and might be willing to consider allocating to active managers that have mandates which provide for greater freedom in portfolio construction to add insight.

While there are numerous choices available for investors Lonsec recommends advisors take careful note of the nature of any potential vehicle under consideration, as highlighted earlier the opportunity set for Australian investors is not only ever-growing, but increasingly diverse. While Lonsec considers an emerging markets exposure to be a logical inclusion in a well diversified portfolio, caution should also be taken to ensure the nature of investment is appropriate for the client.

IMPORTANT NOTICE: The following relate to this document published by Lonsec Limited ABN 56 061 751 102 (“Lonsec”) and should be read before making any investment decision about the product(s).

Disclosure at the date of publication: Lonsec receives a fee from the fund Manager for rating the product(s) using comprehensive and objective criteria. Lonsec‟s fee is not linked to the rating outcome. Costs incurred during the rating process of international funds, including travel and accommodation expenses are paid for by the fund Manager to enable on-site reviews. Lonsec does not hold the product(s) referred to in this document. Lonsec‟s representatives and/or their associates may hold the product(s) referred to in this document, but detail of these holdings are not known to the Analyst(s).

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