According to global bank Standard Chartered, the Chinese and Indian economies are expected to more than triple between 2017 and 2030. In fact, China’s Gross Domestic Product (a measure of a country’s economic output) is predicted to be more than double the USA. This is because the International Monetary Fund predicts that emerging economy growth rates will be nearly three times higher than developed economies. However, investing in emerging markets is not for the fainthearted.
Developed versus emerging markets
Stock markets are typically classified as either developed or emerging markets. Developed markets have a robust and reliable financial system. The country must be open to foreign ownership, ease of capital movement, and efficiency of market institutions. As such, the governments disclosure and regulatory regime is aimed at providing investors with reliable and trustworthy information. The largest developed economies include USA (accounts for 62.8% of all developed markets), Japan (8.4%), UK (5.5%), France (3.8%) and 19 other smaller countries including Australia.
However, emerging markets are less developed. Their financial systems do not have the same level of transparency, accountability and regulatory oversight. The largest emerging markets include China (33%), Korea (13%), Taiwan (11.4%) and India (9%) plus 22 additional countries.
Indexing doesn’t work as well in emerging markets
If you have been a reader of this blog for some time, you would be well aware by now that I’m a strong believer in passive (index) investing. Passive investing is low-cost, very diversified way of investing in a particular market or asset class. It only employs rules-based methodologies – meaning that you don’t pay for expensive fund managers and we can back-test results (i.e. work out what the results would have been if you employed the same rules-based approach over the past 20 years for example).
There’s overwhelming evidence that confirms passive investing produces higher returns in the long run. For example, based on data prepared by S&P Dow Jones Indices, only 16% of active fund managers have beaten the Australian index (ASX200) and less than 11% have beaten the US index (S&P500) over the past 15 years. But this data is a bit deceptive, because its not the same fund managers for the whole period. In fact, any out-performance rarely persists for more than a couple of years – which means you need a crystal ball to work out which active fund manager to switch to every few years. This is a flawed strategy in my opinion – which is why rules-based, passive investing is superior.
However, when it comes to investing in emerging markets, indexing doesn’t always perform as well as it does in developed markets.
When investing in developed markets, many studies show that the key is to diversify your portfolio as much as possible. Of course, you should employ various value-based indexing strategies, particularly in this market. Lack of diversification is the number one cause of poor returns. So, a blanket-based approach works best.
However, when investing in emerging markets, the key is to avoid the poor-quality companies and over-valued companies. You cannot rely on the market to accurately help you identify a poor-quality business, like you can in developed markets. Therefore, you must be very selective with what you invest in. That is why active investing can produce better outcomes when investing in emerging markets.
In my view, you should employ a high-conviction active manager that is very selective and disciplined with what they invest in. You only want them to invest in very high-quality businesses that are fairly priced.
The “President Trump effect”
Emerging market valuations are currently low by historical measures. Stock markets dislike uncertainty and tend to price in worst case scenarios. The USA/China trade tensions have had a negative impact on emerging market valuations. This indicates that it’s probably a good time to buy now or, put differently, your downside risks are relatively limited.
According to modelling produced by US research house Research Affiliates, there is a 90% probability that, over the next decade, emerging market investment returns will be in the range of 4.3% and 11.1% p.a. This modelling is prepared using the CAPE ratio which has been a very accurate predictor of subsequent returns.
Over the past 5 years, my preferred investment managers (including Martin Currie and Fidelity), have produced double-digit investment returns (10.9%-12.3% p.a.). This compares favourably to Vanguard for example (the largest index manager in the world) at 7.62% p.a.
It is also possible to be more focused with emerging market investments through targeting specific growth industries such as technology. For example, BetaShares has a product that invests in the top 50 tech companies in Asia such as Alibaba, Samsung, Taiwan Semiconductor, gaming company Tencent. These are currently valued on lower multiples than their USA counterparts but arguably have better long-term growth prospects.
Please don’t invest in these funds without first obtaining independent advice. I only share these names with you to give you some examples of emerging market funds.
Please be cautious with your approach
Emerging markets are higher risk investments because they typically have a higher volatility rate. Volatility means that prices can change quickly, and movements can be large. As such, typically, I would not recommend investing more than 5% of a portfolio in emerging markets, if anything at all. Emerging market investments should form part of a diversified portfolio of shares and bonds.
Over the past century, global wealth has centred in the USA and Europe. However, by year 2030 the Chinese and Indian economies are projected to be significantly larger than the USA. All of these countries are in close proximity to Australia and relatively similar time zones. As such, Australia is well-positioned (excuse the pun!) to benefit from this tremendous growth.
Perhaps it’s a good time to start thinking about whether your investments are also well positioned to capture these possible investments returns.