EM equities have delivered strong returns despite heightened volatility.

Emerging markets (EM) equities have delivered strong returns over the long term, despite heightened volatility compared to developed markets, according to a report into the sector by investment research house, Lonsec Research (Lonsec).

In its annual ‘Global Emerging Markets and Regional Equities Sector Review’, Lonsec outlines that 2012 proved an eventful year for emerging market equity investors and expects the sector to grow in prominence in coming years.

The in-depth sector review covers an investment research universe of 27 global EM and Asian equity managed funds.

The main findings of the paper are:

• EM equities have delivered strong returns over the long term, albeit with heightened volatility relative to developed market equities. Lonsec is of the view that investors comfortable with the risk/reward scenario may consider a tiered allocation to the asset class, commencing with an expansive emerging market fund in the first instance.
• While the recent period has been a volatile experience for EM investors, the Lonsec EM equity and Asian equity peer group average performance has exceeded the benchmark over short and long timeframes.
• Home bias in Australian investor portfolios is well known. Lonsec continues to recognise the benefits of global equity exposure and recommends an appropriate allocation to global equities (both developed and EMs) to improve the diversification of portfolios and reduce reliance on the relative fortunes of the Australian equity bourse.
• Recent events in Brazil, Egypt and Turkey are a timely reminder for investors of the heightened political risk in emerging markets.
• Frontier markets, the EMs of the future, are not heavily featured within the current financial product suite, although Lonsec observes some fund managers have the ability to tap into this segment.
• Lonsec’s EM research coverage list continues to expand, reflecting positive regard for the EM economic growth story and local financial product providers looking to tap into growing interest in this equity segment.
• Despite the volatility of recent years, Lonsec expects EMs to grow in prominence within global equity portfolios in coming years.

According to Steven Sweeney, Lonsec Senior Investment Analyst, the sector review observed that EM investors had experienced a rocky road in the past 12 months.

“Overall, 2012 delivered EM investors a welcome improvement in performance after a fairly brutal year in 2011.

“Performance during the first half of 2012 was dominated by lingering poor sentiment from European sovereign debt concerns and Chinese economic contraction. An easing of these fears in the latter half of the year saw an increase in the demand for EM equities,” Mr Sweeney said.

The Lonsec review found that 2013 triggered further disruption for EM equity investors with debate around the end of the US Federal Reserve’s stimulus program causing a selloff in EMs.

“Forever the hostage to risk appetite, the outlook for EM equities in the second half of the year remains clouded, however opportunities undoubtedly exist for contrarian investors with the benchmark trading at historically cheap levels,” said Mr Sweeney.

“The EM universe captures 21 countries at varying stages of economic and political development and fortunes can quickly swing for individual nations – this year’s market darling is quite often next year’s cellar dweller.

“EM Equities should not be treated as a play area for the casual day trading investor – there are numerous risks requiring specialist skills and tailored investment approaches. Fortunately, the Lonsec universe includes a number of specialist EM managers

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Six new funds were reviewed and included in Lonsec’s recommended list this year, including the Premium Asia Fund, Macquarie BRIC Advantage Fund (hedged and unhedged and the All Star Nomura China Fund.

Steve Sweeney, Senior Investment Analyst, commented, “The addition of new funds 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.”

Observations from Lonsec’s review

Developments on the playing field

Emerging markets remain transitional economies, generally growing at 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 a greater level of foreign direct investment and in turn, promote increased local investment.

“If an emerging economy reaches sufficient progress, it can move towards developed status, as the likes of Singapore and Hong Kong have achieved,” commented Sweeney.

“Israel is the most recently upwardly mobile economy to make the transition from developing to developed status.”

There are 26 countries in the so called Frontier Market index covering areas as diverse as Africa (Kenya, Tunisia and Nigeria), the Baltics (Estonia and Lithuania), the Balkans (Bulgaria, Croatia and Serbia) and the Middle East (Qatar and Kuwait). These are markets characterised as having high growth rates but lower market capitalisation and liquidity than more developed emerging markets.

“Safe to say, the majority of emerging markets managers do not invest in frontier markets within their core emerging markets funds,” said Sweeney.

“However, some mangers, such as Templeton and Schroder have a considerable heritage as early entrants into these markets and offer institutional investors access to frontier markets.”

Emerging markets continue to grow in size, thereby supporting continued product development and investment choice, as evident in Lonsec’s research coverage in this area, which has increased from seven funds in 2007 to 20 funds today.

Asia – a global equities sweet spot

Asia is a key regional component of emerging markets investment making up about 55% of the MSCI Emerging Markets Index including India.  Asia emerged from the credit crunch with the strongest buy signal of any region. Importantly the rally was broad based and not just focused on China, which actually lagged many other Asian markets through 2009, although clearly the resilience of the Chinese economy was a major factor influencing regional performance.

“Indonesia and India were the standout market performers rising by 117% and 94% respectively in US dollar terms,” said Sweeney. Performance across the sector has varied depending on the investor’s belief in the sustainability of the market rally in 2009 and to some extent the portfolio exposure to these supercharged economies.

“It is a common view among both traditional global equities managers and GEMs managers that emerging markets and Asia in particularly, will serve as the engine room of global growth for the foreseeable future.”

Asia expands economic influence…

A theme evident among investment managers is that expanding Asian demand will increasingly influence economic growth in Asian economies. While exports remain important to regional growth, many expect the Chinese consumer to drive the world economy for the coming decade, thereby promoting increased regional self-reliance.

“You can often see a powerful consumer discretionary story in emerging market portfolios contrasting to traditional developed global equity managers wrestling with the dynamics of mature markets,” said Sweeney.

“Positive aspirational demographics will drive increasing consumer spending power as these economies transition from export dependence to domestic demand and consumption.”

…and in the boardroom too

There are the beginnings of a powershift in corporate headquarters from West to the East. The rise of Asia is cascading down to all levels of investment resourcing with Lonsec observing continued growth in Asian and emerging market teams seemingly at the expense of other regional teams.

“Asia and emerging markets are a leading growth segment for the global wealth management community and this increased resourcing and focus is an encouraging result for Asian and GEM investors,” commented Sweeney.

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