How to gain emerging market exposure

IT IS a well-known story. Emerging markets are playing a more significant role in global economic growth. Recent research from PwC has highlighted that emerging market GDP will exceed that of developed markets, in terms of purchasing power parity (which adjusts for differences in exchange rates), for the first time in 2013.

Since 2002, the FTSE emerging index has risen by 380 per cent, compared to the FTSE developed index’s 120 per cent. And data from the Investment Management Association shows that 2012 was a record year for emerging market investment, as UK retail investors poured in £1.6bn.

The advantages are clear. But given the myriad ways to invest, investors must make important choices about the most appropriate way to add exposure to their portfolios.

One problem is that the term emerging markets is vague, covering economies like the BRICs (Brazil, Russia, India, China), all the way to some Latin American and European nations (like Poland and Hungary). So the tough decisions – like choosing a country, region or index to invest in – remain important.

Emerging markets also do not insulate you from shocks in the developed world; correlations between the two are converging. And despite strong growth, they are not get-rich-quick schemes. Jeff Molitor of Vanguard suggests that all equity investments should have a five to 10 year investment horizon: “Making short-term bets is dangerous.”

Developing markets can also be opaque, and plagued by lax corporate governance. Unstable government policy may add to this uncertainty. So inexperienced investors should seek financial advice before investing.

In addition, the popularity of emerging markets has begotten a range of different investment vehicles and strategies. For most, the choice should boil down to how actively you prefer your investments to be managed.

A passive investor can choose to invest in an index at the country, regional, or sector level. There are numerous tracker funds on offer, like Vanguard’s emerging market index fund, which tracks the MSCI emerging markets index. The fund’s diversification helps to ride out volatility in individual countries or equities. It is also low-cost, with an initial charge of 0.25 per cent of assets under management (AUM), and an annual expense ratio of only 0.55 per cent.

Recently, investors have flocked to exchange-traded funds (ETFs) – a security that tracks the performance of an index, or other type of asset. Unlike open-ended investment companies and unit trusts, ETFs are listed on a stock exchange. This can offer better liquidity, and also give more transparency, helping you to fully understand the constitution of the fund.

The iShares BRIC 50 ETF, for example, tracks the performance of the 50 largest BRIC-based companies. It does not charge an entry or exit fee (brokers do levy around £10 per transaction), but has a 0.74 per cent annual charge of AUM.

There are different types of ETFs. Vanilla ETFs physically invest in securities; synthetic ETFs use derivatives to mirror an index’s performance, and do not invest in the underlying assets. This makes them cheaper, but also more risky: Stephen Cohen of iShares notes that investors are specifically more concerned about counterparty risks associated with using derivatives, and this has dampened the appeal of synthetic ETFs of late.

If you are considering a synthetic ETF, Cohen suggests that you find out how the fund is collateralised, who the counterparties are, and how liquid these instruments are. “Drill in to understand how they work. Not all ETFs are the same.” Also, check how successful the fund manager is at tracking the benchmark index.

The advantage of an actively-managed fund is that an expert fund manager will pick equities they believe will outperform the market. Sam Mahtani of F&C, for instance, uses a top-down approach to identify these companies.

Inevitably you pay more for these funds. The F&C emerging markets fund charges a 1.5 per cent annual management fee, and an initial charge of 5 per cent (although some brokers may waive this). But sometimes active management is worth the cost; Mahtani’s fund outperformed his peers by around 5 per cent in 2012. Active managers also have the flexibility to adjust weightings according to their view of the macro environment, whereas ETFs and trackers mirror the weighting of their benchmark index.

Fund managers have different investment criteria, so look for those with a strong track record. Molitor says “the active approach is good when you have talented managers, and reasonable costs.” High administrative charges can make it difficult, even for the best managers, to deliver value to investors.

Mahtani uses a five-step approach, looking at a company’s business model, management, corporate governance, its medium-term outlook, and the macro risks.

More confident retail investors may opt to identify opportunities themselves. And they could look closer to home; there are plenty of equities listed in developed markets that are exposed to emerging markets, perhaps offering a safer way to invest.

In the UK, the likes of Diageo (which earns 26 per cent of its revenues from emerging markets), SABMiller (53 per cent) and British American Tobacco (43 per cent), are all plugged in to the macro trends. But the DIY approach is risky. Even large investors have been caught out. Hedge fund manager John Paulson’s investment in the China-based, Canadian-listed company Sino Forrest is a notorious example. Paulson eventually lost $720m (£460m).

But in spite of this, the investment adage that the more risk you take, the higher reward you should expect, rings true. So investors should consider having an emerging market allocation. Just remember to approach the proposition in a diversified way, with a sensible portfolio weighting. There will be plenty more Paulsons in the future; don’t be one of them.