Emerging markets appear attractive despite the risks

EMERGING markets have outperformed developed markets over the last decade, and since the financial crisis, investors have been piling into funds with exposure to these economies. Investment Management Association data shows that UK retail investors pumped £1.1bn into the sector in 2012, compared to only £174m in 2007.

Investing in emerging market stocks is not without risk. “It has been a year of disappointment,” says Alia Yousuf of ACPI Investment Managers. The FTSE emerging index has risen by 11 per cent over the last 12 months, compared to 14.5 per cent for the FTSE developed index.

Emerging markets have also been characterised by volatility. There have been years when they have grown by over 80 per cent (2009), and others when they have lost over 50 per cent (2008). But over the last decade, the FTSE emerging index has risen by nearly 300 per cent. Whether they can maintain this pace of growth is debatable. Yousuf says that “there has been a lot of hype around emerging markets, and when retail investors get in it’s usually a little bit late”.

But there is still a place for them within your portfolio, and they will remain attractive in 2013. Morgan Stanley forecasts that combined emerging market economic growth will be around 5.5 per cent in 2013. But economic growth doesn’t necessarily translate into stellar equity market performance.

Mike Ingram of BGC Brokers describes emerging markets as a “beta play,” meaning that their performance will be amplified by that of developed markets. He thinks that emerging market stocks could grow by 15 per cent in 2013.

To achieve these sorts of returns, you will need to take on risk, and there are plenty associated with emerging markets. Their performance is contingent on that of developed market stocks. “They won’t perform if the rest of the world is going down the pan,” highlighting how reliant emerging markets – and their corporates – are on exports to developed economies. Subdued demand from developed nations could drag emerging market shares lower.

Political risk and transparency are also key considerations. The Indian government’s recent attempt to retrospectively squeeze more VAT out of Vodafone is just one example. The reliability of economic and corporate data is another concern.

Practically, there are also liquidity risks, meaning that if you try to sell shares in an emerging market company, there may be few buyers. This can cause volatile swings in the prices of shares.

To help mitigate these risks, inexperienced investors could invest through a diversified fund. Aberdeen’s emerging market fund is an option; it has delivered 18 per cent over the last 12 months, beating the sector average.

For something more specific, Ingram recommends China. “It is due for a comeback,” he says, and “at four year lows, it should see a turnaround in 2013 subject to a supportive risk environment”. Now that the country’s leadership transition has happened, there is also more policy certainty.

While there is room for emerging market shares within your portfolio, their value lies in the diversification they can offer. They may not be appropriate as a significant chunk of your asset allocation. As Ingram says, they offer diversifcation of equity exposure, not a hedge against problems in the developed world.