EM businesses have the full advantage of fast growth in all aspects of their operation, leading to faster growth overall.
“The more evolved a business or the marketplace is, the harder it is to grow.”
While there is a clear potential upside to investing in EMs, the risks should not be underestimated. Some of the key aspects to be wary of include sector biases, the effect of government policy, and general volatility. Emerging economies usually rely on a narrow range of sectors – especially agriculture and commodities – to fuel their development. Because of the homogeneous nature of commodities, the price is not set by the producer, making markets that are dependent on them vulnerable to global price fluctuations.
When the price of oil plummeted in the midst of the financial crisis, for example, Russia suffered a significant drop in GDP. Patrick Farrell, head of Advance Investment Solutions for BT Financial Group, says China has evolved beyond an agricultural economy and is now in an industrial phase.
India has effectively leap-frogged the industrial phase, becoming a service-based economy, including a significant number of call-centre services to developed economies. He points out that while it would be complicated for countries that have outsourced their manufacturing centres to Asia to bring them back in-house, it’s relatively easy to retract service contracts, leaving the Indian economy somewhat more vulnerable.
A further risk is in the protection of personal and intellectual rights. Developed markets tend to have more sophisticated checks and balances, while legal systems may not be enforced as rigorously in EMs. In some cases, EM systems are complex to negotiate and may even be compromised by corruption. Political intervention can also dramatically affect the way an EM functions.
EMs are often relatively unstable and governments can make sudden changes to rules and regulations, take actions to restrict foreign investment, or even nationalise corporations. An example of the effect of political intervention was the recent increase in tax on foreign investment by the Brazilian government.
‘The key aspects to be wary of include sector biases and the effect of government policy’
In another example, many Chinese companies are controlled by the state and there’s no guarantee that shareholders’ interests will be aligned with the government’s interests. Given the nature of EMs, before moving to the stage of selecting a product or a fund manager, planners should establish an investor’s risk profile, age and time horizon. If an investor doesn’t have the cash-flow, the time or the stomach to ride out short-term volatility, EMs are probably not the most appropriate investment vehicle.
If EMs are a suitable investment, asking the right questions will help determine the right asset allocation for a particular individual’s circumstances. Farrell points out that many investors already have an exposure to EMs through their existing allocation to global multinational companies, which have growth exposure in those markets.
In terms of asset allocation, he suggests a reasonable further allocation to direct investment in EMs might be around 10 per cent of the total international exposure to equities. Alternatively, Urquhart suggests that a reasonable allocation to overseas equity markets would be around 25 per cent, with around onethird of that directly invested in EMs.
“You’re not looking at where those markets are today, but where they’re going to be in five to 10 years. If those markets are going to make up half of the global output and you only have a 10 per cent representation in your EMs exposure, that’s clearly out of kilter.
“The simplest and safest way to invest is via a fund. Anyone considering directly investing in specific shares in an EM would need to be very careful.”
Naeimi is far more aggressive in his recommendations for EM exposure, saying he personally has 80 per cent of his own superannuation equities allocation in EMs and only 20 per cent in developed markets. He says even a more conservative investor should have around 50 per cent of their total portfolio in equities and around two-thirds of that in EMs.
“The risk is higher, but the fundamentals for EMs are much sounder than they were; where before we saw overvalued currency and budget deficits, we’re now seeing the opposite with government savings and stable currencies.”
It’s Farrell’s belief that India and China will dominate the scene for the next decade or two. Urquhart also lists those two markets as being amongst the EMs with the most potential growth going forward, in addition to Indonesia and Thailand.
“Indonesia has a lot of headroom and is becoming politically more stable. Incomes are growing, interest rates have dropped to single digits and inflation is now under control.
“While Thailand still has political risk, it has strong agricultural prices and auto exports. Ford has just made a half-a-billion-dollar manufacturing investment there, which is a big vote of confidence.”
Farrell says sector-wise, technology and media look promising, while consumer goods and retail generally are likely to grow as wages in those countries continue to grow.
Naeimi agrees Asia represents the top pick for growth going forward, followed by Latin America, due to its richness in commodities. Farrell says while the trend is going towards specific country funds, he believes this approach is fraught with risk, adding that aggressive investment in any one region or sector could easily result in a bubble.
“Ideally, you need fund managers who can move funds about and have a diversified approach. Investors and planners should look for equity managers with EM capability, who understand the risks and have an exit strategy,” he says.
Naeimi agrees on the potential for pricing bubbles, saying that while there’s no evidence of one approaching any time soon, they are sure to come at some point.
“Wherever there’s potential for a bubble, it’s better to get in early. By the very nature of an EM fund, a good analyst can add so much more value than in a developed market fund,” he says.
As an alternative to equities, Farrell says EM bonds look quite attractive and that yields will improve to a similar level as those of developed markets over time.
“As EMs build up their credit ratings and manage inflation, confidence in those markets will also improve and bonds will become attractive for income. Bonds could be a good way to access EMs now, with the benefit of currency appreciation as those economies improve,” he says.
Naeimi agrees the corporate bond sector could be interesting, suggesting there is likely to be a need for funds in the future. He recommends some allocation to Asia in particular, although adding that it’s hard to get excited about EM bonds in the short term. Urquhart agrees the fixed-income bond markets in EMs are somewhat underdeveloped currently.
“With the governments in surplus, there’s not a large market for bonds,” he says.
“And with balance sheets strong, many companies don’t need to issue them. There’s an overall shortage of supply, and were they available, the yield would be lower in any case.
“The Asian crisis in particular taught those countries a lot about debt, and the lessons of the past couple of years have just been a refresher course.”
Farrell says exchange-traded funds (ETFs) are another option for investors and can supply a broad and cost-effective solution for diversification. All three commentators agree that an expert fund manager who understands the culture and the dynamics of what’s happening domestically and overseas is a must.
“An expert is not necessarily going to just follow trends and is able to invest opportunistically,” Farrell says.
“EMs will continue to develop, and with that will come opportunity for investors,” he says. “But critically, it’s important to remain cognisant of risk and enlist advice from experts in those markets.”
