The majority of international share man­aged funds available in Australia invest primarily in stocks from the major developed economies, including the United States, the United Kingdom, Japan, and the European nations. In recent times, however, a number of funds have been launched which offer access to the upside potential of investing in companies from the world’s fast-growing developing economies.

A useful definition of an emerging market is one adopted by the World Bank: an economy with a low to middle per capita income. These are generally countries which have begun to open their economies to the world, accompanied by economic reforms and greater acceptance of foreign invest­ment, and which are in the process of developing more sophisticated and liquid capital markets.

The most common market index used by fund managers as a benchmark for investing in this area is the MSCI Emerging Markets Index, which com­prises stocks from 25 countries including Argen­tina, Brazil, the Czech Republic, Hungary, Mexico, Thailand, and Vietnam. Because of the nature of the countries in which they invest, emerging market funds are more likely than their developed counter­parts to be affected by political risks.

Nineteen retail and wholesale diversified emerging markets funds are currently offered in Australia (Table 1 below), as well as several single-country funds which provide exposure to compa­nies listed in or trading with China and India. In addition there are also 10 superannuation funds and another eight allocated pensions, offered by the same fund managers and run using the same approaches to investing.

Why Aren’t There More?

Australians have fewer opportunities to invest in diversified emerging markets funds than inves­tors in Europe. We have a greater number of funds which invest specifically in the emerging Asian countries, because they represent a substantial share of the world’s fastest-growing markets and also because they’re in our backyard geographically, as the former Soviet Bloc countries are for Euro­pean investors. Also, most fund managers, dealer groups and advisers tend to stick with offering and recommending diversified global share funds, which invest primarily in well-known, more liquid developed world stocks.

The Track Record

While returns from emerging markets funds have been strong for the past four calendar years, the key characteristic to consider when assessing the performance of these funds is their volatility. One way of illustrating this is to look at trends in average calendar year-end returns. As Figure 1 shows, average returns from these emerging markets funds have been strong in recent years; reaching above 40.0 percent over the year to 31 De­cember 2005, for instance. But these funds’ returns have also had some pretty wild swings. For the year ending 31 December 1998, the average return was -17.53 percent, in the aftermath of the severe cor­rection in Asian markets. This then became 56.91 percent for the 1999 calendar year, before swing­ing back again to -16.41 percent for the year to 31 December 2000.

The Funds

The emerging markets funds can be broadly grouped into two categories: passively-managed op­tions which track a representative basket of stocks or those which invest on the basis of quantitative models and actively-managed funds.

In the first group we can place Vanguard Wholesale – Emerging Markets Shares Index which currently has 831 companies from 23 countries, but excludes stocks from Colombia and Pakistan. Another in this group, Dimensional – Emerging Markets; GMO Emerging Markets is currently closed to new investment.

The second group of funds are managed actively. They include ING OneAnswer Invest­ment Portfolio – ING Global Emerging Markets Share and ING Wholesale – ING Global Emerg­ing Markets. These funds are run by a team that assesses broader macroeconomic and geopolitical conditions and then looks for companies with improving cash flows, solid balance sheets and at­tractive valuations.

Aberdeen – Emerging Opportunities focuses more on bottom-up factors, looking in depth at individual companies rather than top-down factors such as economic trends.

ABN AMRO Emerging Markets Equity uses a “growth at a reasonable price” approach to invest­ing and focuses on assessing a company’s financial strength, competitiveness, profitability, growth prospects and management quality.

Colonial First State Wholesale Global Emerg­ing Market’s team recently commented that it expected emerging market volatility to increase, as global liquidity was affected by jitters emanating from the meltdown in the US sub-prime mortgage sector.

Lazard Emerging Markets I Class invests in what the firm describes as “undervalued, underap­preciated, and financially productive” stocks. Lazard is also the investment manager for the now-closed Macquarie Emerging Markets Share.

The Legg Mason – Emerging Market invests in companies the firm considers to have strong growth perspectives. Legg Mason also managed the under­lying assets of the ipac Strategic Investment Service – Global Emerging Markets. Macquarie offers two options with their Macquarie Globalis BRIC Advantage, one is hedged, the other is not. These funds focus in particular on the so-called ‘BRIC’ countries of Brazil, Russia, India, and China.

Schroder Global Emerging Markets ranks countries according to a six-factor quantitative model and rank stocks by the company’s likeli­hood of outperforming its relevant country index and UBS Emerging Markets Equity, an unhedged offering launched in this market in March this year, invests in 100-175 emerging market shares.

The Price Tag

The average ongoing fee for the retail emerging markets funds (classified as those with an upfront investment minimum of less than A$50,000) is currently 2.08 percent each year; for the wholesale funds, it’s 1.07 percent. In retail, this is about 10 basis points more than you’d pay on average for a diversified developed market international share fund while the 1.07 percent average annual cost for the wholesale emerging market options is about the same as for developed market equivalents.

Client Strategy

The principal benefit of an emerging mar­kets fund is the opportunity it provides to invest in stocks and countries which don’t fea­ture in developed market funds, longer-term growth opportunities and the diversification poten­tial from offshore investment. However, Morning­star suggests you should only consider investing clients in an emerging markets fund if they have a long investment time horizon, patience, the ability to ride out short-term periods of pronounced mar­ket volatility and a high tolerance for risk.

You may have gathered from the frequency of the same names cropping up in the discussion that there is a high degree of commonality among their underlying stockholdings, so investing in more than one of these emerging market funds would not introduce any meaningful diversification into a client’s portfolio. Our correlation studies also show that these funds’ returns have all historically moved in the same direction.

Phillip Gray is Morningstar’s Editorial & Communica­tions Manager. He can be reached at [email protected] He does not own units in any of the funds mentioned above.

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