For investors returning to emerging markets, here are seven things you should think about

Global asset manager AllianceBernstein said today that there were seven points investors should consider if they wish to join the move back into emerging markets.

“After several years of disappointing returns, emerging-market equities are regaining interest, attracting flows and outperforming their developed-market counterparts this year,” said Morgan C. Harting, an Emerging Markets Portfolio Manager based at AllianceBernstein’s New York office.

“Given the current global investment climate, and the fact that emerging markets have changed in significant ways during the last decade, we have drawn up a list of seven points we think investors should consider as they reallocate to emerging markets.” They are:

1. Earnings growth, finally. Over time, stock returns are driven by earnings growth. At the index level, emerging-market (EM) stocks didn’t deliver any earnings growth from 2010 to 2013 so, not surprisingly, they lagged. This year, however, companies are expected to grow earnings per share by 9%, followed by 12% growth in 2015, providing a stronger foundation for stock prices.

2. Monitor global events, but don’t become paralyzed. In a year that included Russia’s invasion of Ukraine, renewed Middle East unrest, China’s slowing economy, the tapering of the US Federal Reserve’s bond buying, a drought in Brazil and elections in India and Indonesia, EM equities have returned a respectable 15%. Lesson: it pays to stay disciplined in the face of headline risks.

3. The easy EM beta trade is likely behind us. Over the past decade, passive exposure to EM stocks outperformed passive exposure to developed-market (DM) stocks by about 3% annualized, propelled by EM’s more rapid relative economic growth, a big profitability and earnings growth advantage and a starting point of depressed stock valuations. Those advantages are more muted today, so the return potential from passive EM exposure is also likely to be more muted in future.

4. Volatility is a bigger hurdle. With EM index returns likely facing greater headwinds in future, we believe that allocations to EM equities will have to work harder to compensate for their far greater volatility. In our view, that means finding ways to generate meaningfully higher returns than the index and/or employing strategies to reduce volatility. In either case, the bar is higher for passive index-tracking approaches than it is for active strategies, which have more room to manoeuvre.

5. Good news: alpha potential remains high. The flow of information about countries and companies is slower and less transparent in developing markets, creating mispricings that resourceful stock pickers can exploit. Valuation, profitability and price momentum continue to be more productive in driving excess returns in EM than in DM, particularly when combined.

Disciplined approaches that target historically reliable return drivers should continue to be rewarded.

6. Prepare for the end of the “safety trade.” Amid decelerating EM economic growth and lingering post-crisis uncertainties, investors have been paying bigger and bigger premiums for EM companies with strong current performance, while shunning companies whose earnings growth may come further into the future. The valuation spread between the two has reached an extreme only seen in about 5% of periods over the past 20 years. These junctures have tended to be the most productive times to rebalance to value-investing strategies, even at the expense of some quality. Index trackers risk being overly concentrated in yesterday’s pricier winners.

7. Diversify your exposure with multi-asset strategies and smaller markets. There are also ways to tap EM return potential while diversifying risk. For example, multi-asset strategies can generate equity-like returns with less volatility by broadening the investment opportunity set to encompass select EM bonds. Investors should also consider adding exposure to smaller developing-world markets, many of which are growing quickly yet remain less correlated than the BRICs, and are often riper for stock-picking because of greater information inefficiencies. Ten years from now, we expect markets such as Vietnam, Nigeria, Colombia and Qatar to become more significant constituents in global portfolios.