Most investment experts and advisers agree that long-term investors should have some exposure to emerging markets such as Asia and Latin America.
Ben Yearsley, investment manager at Hargreaves Lansdown, says: “In my view, all investors with longer-term goals could benefit from emerging market exposure of some kind.”
David Coombs, head of multi-asset investments at Rathbones, agrees: “All investors should have some exposure to emerging markets. Unless they have a short time horizon of say one year, in which case, forget it.”
But the question remains, what type of exposure emerging markets investors should choose?
Fixed income
Over the past 15 years, emerging market fixed income has outperformed many – if not all – other asset classes. But the times are changing and emerging markets are increasingly getting investment-grade (or above BBB-) ratings, with some 60% of emerging markets now rated as investment grade.
Dean Newman, head of emerging market equities at Invesco Perpetual, says: “Over the past five years, the tendency has been for emerging market sovereign debt ratings to get better and better. What is more, this has come at a time when developed countries are having their ratings downgraded, leading to an interesting convergence.”
Standard & Poor’s currently rates bonds from China, India and Brazil as AA-, BBB- and BBB, while Italian bonds are rated BBB+, Portuguese bonds BB and Greek bonds CC. Emerging market yields and returns are far closer to those available in developed markets as a result. And the view that emerging market fixed income is riskier than developed market fixed income may have to be reassessed.
Newman adds: “In the past, you could have said both emerging market debt and emerging market equities were suitable for investors with a high appetite for risk. But now that fixed income spreads have narrowed, the situation is not as clear cut.”
There is also some concern that this change has not yet been priced into the market, leaving emerging market debt looking quite expensive.
Coombs says: “There are some fixed income opportunities in individual countries, but overall emerging market debt spreads have narrowed as developed market debt spreads have widened. That is why I currently have less than 1% exposure to emerging market fixed income.”
For what reason?
Despite potentially less risk, Yearsley is also worried that many UK investors buy emerging market sovereign debt for the wrong reasons.
“Emerging market fixed income has done very well over the long term,” he says. “Consequently, there is a lot of noise about it that you do not get with emerging market equities. This makes me a bit nervous because, while the returns can be great, the downside can be very big too.
“While some people see EM fixed income as a spicier way to invest in bonds, the risk/reward correlation is actually more like equities.”
The noise he refers to is illustrated by the number of EM fixed income funds and schemes now available, including a new iShares ETF focusing on Asian local government debt. Aimed at “investors searching for a steady stream of income”, it offers exposure to a basket of bonds from countries such as Thailand, South Korea, Philippines, Malaysia and Indonesia.
Axel Lomholt, head of iShares product development, EMEA, comments: “European investors are continuing to search for new ways in which they can secure sustainable income streams. As this hunt for yield continues, we are seeing significant interest in fixed income ETFs.”
Darius McDermott, managing director of Chelsea Financial Services, argues that for most investors paying higher charges for managed funds could prove a sensible move.
“I am not anti-ETFs but in a specialist area such as this, a good manager should be able to add value,” he says. “My current favourite is the Investec Emerging Market Local Currency Debt Fund, managed by Peter Eerdmans. Depending on his or her risk profile, I would have no qualms about advising an investor with, say, £50,000 in fixed interest investments to diversify by putting 5% or 10% of that into this fund.”
Yearsley would advise those keen for some exposure to emerging market fixed income to buy the Schroders Absolute Return Emerging Markets Fund over a more focused scheme.
Equities
When it comes to EM equities, there is a general consensus that today’s investors need to take a very different approach to those buying into the market ten years ago.
Derry Pickford, macro analyst at Ashburton, says: “Things have changed since the mid-’00s, when EM equities were an easy buy. Now, investors have to be much more selective, particularly as some EM currencies look quite expensive at the moment.”
In China and India, for example, Pickford believes that while there are some good opportunities for equity investors, these come in the form of individual stocks rather than the markets as a whole, but warns that they are stock-pickers’ markets and you need to be careful what you buy.
Another change is that firms in the developing world, which have generally preferred to use profits to grow the business rather than give them to shareholders, have started to change their tactics.
Data from Reuters suggests that EM companies will pay out some 35% of their retained earnings in dividends this year, pushing emerging dividend yields – the ratio of dividends to the share price – up to 2.6%. That is just below the developed market average.
So global investors in search of high dividends have started looking to emerging market equities, recasting them as yield-bearing, income-providing assets.
McDermott explains: “Dividends accounted for about a third of total EM equity returns over the past ten years. But over the past five years, that jumps to 50% – a clear sign of the way things are going.”
Better value
This is likely to be of interest to income investors, especially as many emerging market specialists believe equities offer better value for money than fixed income at the moment.
“While I believe emerging market corporate bonds will become more attractive over the next few years, it is currently quite a niche area,” Coombs says. “But EM equities have been looking attractive for the past three to four months. We like emerging Europe, which is dominated by Russia, and currently valued at about seven to eight times earnings.”
Newman says: “There is a great long-term investment case for emerging market equities. Brazil, for example, has now overtaken the UK as the sixth-largest economy in the world but its stock market is only about 20% to 25% of the size. In ten years time, why would it not be as big?”
