Brave-hearted investors can still expect reasonable returns from emerging markets investment but should adopt a measured long term approach and be prepared for periodic selloffs, according to a new report from research house Lonsec.

Lonsec has released its annual Global Emerging Markets and Regional Equities Sector Review which showed that for the first time since 2010, emerging markets outperformed Australian equities for the year to June 2015.

However, the report highlighted that emerging markets investors continue to face substantial volatility, as evident in recent months with performance fluctuating across different countries and regions.

According to the report, Asian equities delivered 15% in 2014 and 27% for the year to 30 June 2015, benefiting from another strong year for Indian equities and a rebound in sentiment for Chinese equities. Indian equities proved the standout performer delivering 35% in 2014 and 27% for the year to 30 June 2015. However, another half of the so called ‘BRIC’ economies – Brazil and Russia – were out of favour due to the weakness in the commodity cycle, sliding currency and political tension.

Ongoing volatility has continued to spook investors with Lonsec predicting that this year is likely to be the third consecutive year of outflows from the asset class due to ongoing global growth fears.

Steven Sweeney, Senior Investment Analyst at Lonsec and principal author of the report said, “Sentiment for emerging markets is weak due to concerns about the impact of predicted rate rises in the US, broad currency volatility thanks to a rising Greenback and concerns about China’s ability to manage its economic slowdown.”

Nevertheless, there remained an alpha opportunity in emerging markets for those fund managers applying a top down research process.

“Country factors, which include politics, economic metrics and money flows, continue to have a bearing on performance in emerging markets,” Mr Sweeney said. “For this year, fund managers who positioned portfolios more towards Asia and avoided Russia and Brazil tended to achieve improved performance outcomes.”

“Retail investors and their financial advisers should consider a measured allocation to emerging markets with exposure to higher performing economies, such as Asia, from a long term perspective,” he said.

Challenges in emerging markets

The Lonsec report looks at the performance of 36 emerging market funds during the period for the year to the end of July 2015. The report found that 2014 provided a modest return for emerging market investors with the emerging markets benchmark delivering close to 7% for the year in AUD and 16% for the year to 30 June 2015.

Mr Sweeney said investors and financial advisers need to be aware of ongoing market risk as the segment remains more volatile than global equities.

“Financial advisers should consider client risk tolerance and be mindful of overall exposure to developing economies within the global equities allocation,” he said. “In many ways, the recent swings between buying and selloffs are really just business as usual for emerging markets investors.”

Lonsec also advocates the use of specialist emerging markets funds managers with dedicated personnel and tailored investment approaches to emerging markets.

In terms of ratings, 2015 was notable for a comparatively high degree of ratings movement with three rating upgrades and seven downgrades.

Other key findings of the report include:

• Lonsec Asian median fund performance continues to add alpha, relative to the benchmark, over all timeframes.
• Lonsec active manager emerging markets and Asia equity peer group has performed well over the medium and longer term to 30 June 2015.
• Asian companies now comprise around 70% of the emerging markets benchmark, suggesting Asian funds now represent a reasonable proxy for emerging markets.
• The AUD continued to weaken in 2014/2015 but the majority of funds are unhedged which has aided performance for Australian investors.

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RI Australian Equity funds: positive performance and reduced volatility

Leading research house Lonsec yesterday released its 2014/15 Australian & Global Equity Responsible Investment (RI) Sector Review, highlighting positive performance and reduced volatility for RI Australian Equity funds.

The report revealed that the Lonsec’s Australian equity RI peer group average returned 15.7% for the year to August 2014 and 17.1% p.a. for the three year period, outperforming both the ASX 300 index (14.2% over 1 year to August 2014 and 14.0% p.a. for the three year period) as well as the Lonsec ‘core’ Australian equity peer group (13.8% and 16.6% p.a. over the same periods respectively).

“It’s a common misperception that responsible investment will not achieve a reasonable rate of return on their funds but in reality this is clearly not the case,” said Steven Sweeney, Senior Investment Analyst at Lonsec and principal author of the report. “Pleasingly, while a niche segment, a number of the funds have generated a strong alpha track record over a reasonable period.’

Published for over a decade, Lonsec’s RI universe includes funds adopting a variety of intensity in their responsible investment philosophy from traditional ethical funds that screen out perceived ‘bad’ companies through to ESG funds that look to invest in sustainable companies across the market spectrum that rate highly on ESG factors.

“The challenge for advisers is to recommend the right funds that align with their clients’ ethical investment motivation,” Mr Sweeney said. “Traditional ethical funds have different approaches to ESG funds. For example, some fund managers, such as Perpetual, Australian Ethical and Hunter Hall are providing fossil fuel free options within the Lonsec universe while other Funds are not exempt.”

“Lonsec aims to provide a roadmap for advisers to help them provide suitable fund selection suggestions to meet their client’s objectives,” Mr Sweeney said.

Other key findings of the report include:

• RI funds are more likely to struggle when compared against the benchmark and mainstream peer funds in strongly rising or resource driven markets.
• Most Australian equity RI funds recorded lower volatility than the index over one and three year periods to August 2014.
• There is a recent trend to improve internal RI resourcing to supplement the external service provision.

The 2014/15 Australian & Global Equity Responsible Investment Sector Review covered seven Australian equity and two global equity funds. Lonsec awarded its premier ‘Highly Recommended’ rating to the Perpetual Wholesale Ethical SRI Fund. Five funds were assigned a ‘Recommended’ rating.

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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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The majority of managers in the Lonsec small cap peer group considerably outperformed the benchmark in 2012.

The Lonsec Small Cap Australian Equity Sector Review observed that while small caps recorded a reasonable return, they again underperformed large caps for the year with the broader S&P/ASX 200 delivering a healthy rise of 20.3% for 2012.

“This trend is not unexpected given the more volatile nature of small companies compared to larger peers,” said Steven Sweeney, Lonsec Senior Investment Analyst.

“Small caps will tend to outperform larger caps in periods of more buoyant market sentiment while experiencing more downside weakness when markets are troubled.

“With risk appetite remaining relatively constrained, investors were more comfortable chasing high yield and defensive large caps during 2012 than venturing too heavily into small caps,” Mr Sweeney said.

Should risk appetite improve as appears the case in the current climate, it presents an opportunity for investors to revisit their small cap allocation.

Investment management team stability has been uncommonly positive in the past few years, a beneficial aspect of the bear market, with personnel more likely to be preoccupied with existing responsibilities versus eyeing greener pastures. The prevalence of boutique investment platforms in the sector with high alignment of interest and investment team buy-in has also improved stability.

One factor identified by the review as impacting small cap investment managers is declining market depth.

“Weak capital market conditions prevailed in 2012 with a lack of IPOs, capital raising and merger and acquisition activity limiting a traditional hunting ground for small cap managers,” Mr Sweeney said.

“The IPO market remains in drought and at cyclical lows for industrials. Indeed, 2012 was Australia’s weakest year on record for share market floats, which only totalled $876 million – down 32% from 2011, which was also a weak year.
 
“A dwindling of new opportunities suggests managers are increasingly hunting in a shrinking pool and looking for similar qualities in companies, resulting in a crowded trade scenario with the same companies being widely held.”
 
The Lonsec Review concluded the performance of the average small cap manager in the Lonsec peer groups versus the benchmark gives support to a meaningful allocation to small caps and an active investment approach.

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Steven Sweeney, Senior Investment Analyst, commented, “The past year has tested the resolve of the most ardent emerging market aficionados.”

“Deteriorating investment returns have prompted a bout of head scratching for many EM investors due to the nonsensical reality of US and European equities outperforming emerging markets while the economic fundamentals across both categories were in such divergence.”

The dominant cause of weak performance through 2011 and 2012 was the relentless pulverisation of investor risk appetite.

“Emerging market equity returns have historically been hostage to investor sentiment, and so it proved once again,” said Sweeney.

“With the escalating European sovereign debt crisis – now in its third year – preoccupying global markets, investors were prompted to bunker down and retrieve capital from higher risk assets. While there were periodic bouts of ‘risk on’ often following news of another hefty cache of tax payer funds thrown at governments and failing banks, these proved short-lived.”

The call for increasing EM exposure finds voice…
Nevertheless, there has been growing support for an increased emerging market exposure, particularly from institutional clients. The ascent of the BRICs and emerging Asia with improved economic muscle, robust balance sheets and attractive aspirational demographics suggests historians will regard the 21st century as the age of the emerging world.

“Institutional clients are accessing the sector in increasing allocations,” said Sweeney. “It is timely for advisers to revisit the portfolio radar to ensure the trend does not leave retail clients stuck in the starting blocks.”

…while changing dynamics of the Chinese economy have profound implications for Australia
“As China shifts gear from an export led to a domestic consumption driven story, it may be increasingly difficult for Australian investors to gain exposure to the Asian consumption story through holdings in Australian resource stocks,” explained Sweeney.

“There are also signs that the commodity cycle is peaking, dampening demand for Australian resource stocks. This shift may reduce the Australian equity market’s historical performance correlation with emerging markets.” 

The review
Lonsec’s Global Equity Sector Review encompassed 24 long only global emerging market and Asian equity investment managed funds.

Of these, five attained Lonsec’s top rating of ‘Highly Recommended’; the Aberdeen Asian Opportunities Fund, the Aberdeen Emerging Opportunities Fund, Fidelity Asia Fund, Premium China Fund and the T Rowe Price Asia ex Japan Equity Fund.

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