Tom Bailey considers what investors need to look out for in emerging and frontier market funds that invest in one country – and how to ride out the expected volatility.
Scottish American Investment Company was founded by William Menzies in the 1870s, after a series of visits to the US left him impressed by the wealth and opportunities the rapidly industrialising country presented. Being the most exciting emerging market of its day, America, it was hoped, would provide strong returns for investors in the UK.
Similarly, today, many investors are drawn to emerging markets undergoing their own economic transformations, typically by investing through an actively managed fund or investment trust. While many investors may opt to access such economies through broadly spread emerging market or regional funds or trusts, picking a single-country focused investment has become increasingly popular.
‘There has been a sudden rise in the popularity of single-country emerging market funds,’ notes Chady Jouni, senior portfolio manager at Barclays Wealth Management.
It’s not hard to see why. While emerging markets as a whole have done well in recent years, some individual countries have raced ahead of their peers. The Investment Association’s emerging markets sector returned 46.8 per cent over the past five years, while Asia Pacific excluding Japan returned 70.3 per cent. By contrast, funds in the China/Greater China sector more than doubled in value on average over that timeframe. It’s no surprise that China outperformed its peers in both the emerging market and Asia Pacific sectors, but it does underline an important point: going after a broader grouping of countries can act as a drag on returns.
Changing nature of developing markets
The drive towards single-country funds is also a story of the changed and changing nature of many emerging markets. ‘For context, it’s useful to take a step back and look at how EMs have changed over the last 10 years,’ Jouni says.
Around a decade ago, emerging economies were very different from today. Many were dominated by commodities and raw materials production. Large, sometimes stateowned, firms suffocated them. ‘The energy and materials sectors,’ says Jouni, ‘used to make up about 30 per cent of the MSCI Emerging Markets index, but today they make up less than half of that.’
That is particularly the case in regard to emerging and frontier markets within Asia. Asian economies have seen the proliferation and maturity of a host of exciting businesses, particularly in the tech sector. As Jouni notes: ‘The IT sector has jumped from 12 per cent to nearly 30 per cent of the MSCI Emerging Market index over the past decade.’ This gives active managers more interesting investment prospects. ‘As investors search out today’s winners, it is prompting the launch of single- country funds,’ says Jouni.
Why active is popular
The growth in popularity of country-specific funds has primarily been focused on China and India. Partly this is due to size. China, soon to be the world’s largest economy, has a booming number of listed firms. According to Jouni: ‘If you were to total up domestic Chinese equities, plus the Hong Kong market and Chinese firms listed on US exchanges, it gives you 4,600 companies with a total market cap of $11.7 trillion (£8.7 trillion), second only to the US in size.’ That is a big market for an active manager to play in. Likewise, India is estimated to be the world’s most populous country right now, and is often tipped to overtake China’s economy in the next couple of decades.
The size and rapid advance of each economy also opens up more opportunities for active management to provide strong performance. ‘What’s really interesting about China is that there are a lot of small to mid-cap companies, where active managers can find interesting opportunities to add value,’ says Jouni.
The potential offered by an active manager in Chinese small- and mid-caps can be demonstrated, for instance, by the performance of Matthews China Smaller Companies fund: between June 2017 and June 2018, it achieved total returns of 40 per cent. India-focused funds also offer investors access to a thriving small and mid-cap market, says Jouni. For example the India Capital Growth trust, which focuses on small caps, returned a handsome 42 per cent in 2017.
However, while India and China have been the most popular countries for single-country funds, other countries have also seen a dramatic growth in popularity with overseas investors. VinaCapital Vietnam Opportunity and Vietnam Enterprise Investments, two Vietnam focused investment trusts, were among the most impressive performers in 2017, with many speaking of the country as a ‘mini-China.’
Other country-specific funds are also increasingly seeing the potential of small cap opportunities in the region. Aberdeen New Thai investment trust, which had a stellar rise to fame from 2008 to 2013 but whose share price has effectively flat-lined since then, recently unveiled plans to increase the portfolio’s potential small cap exposure beyond the current level of 35 per cent.
What to watch out for
Investing in a single-country fund or trust requires that investors take into account country-specific risks. One of the biggest potential issues in this regard is currency risk. As the past few months have shown once again, emerging market currencies can be very volatile. A rise in interest rates in the US can spark a run on a local emerging market currency as people favour the better-paying, stronger currency, while currency swings can be disastrous for firms with a large amount of dollar-dominated debt.
However, such short-term risk or volatility is just part and parcel of investing in such economies, argues Andy Ho, who runs the VinaCapital Vietnam Opportunity trust. ‘Investors must take a long-term approach. There is going to be shortterm risk, but investors need patience.’
Ben Yearsley, director of Shore Financial Planning, makes a similar point, noting that ‘whether it’s a frontier, broad emerging, country-specific or a small cap fund, all have the same characteristics in my view: namely, you need to own it for at least a decade to get the best returns and to help smooth out the inevitable volatility.’
However, while volatility should be expected, having a long investing horizon is no guarantee against risk. As the chart (below) shows, had you invested in either Neptune Russia & Greater Russia or BNY Mellon Brazil Equity in 2008, your returns would amount to next to nothing. The risk is that the ‘next big growth story’ may simply not materialise, leaving investors with the choice of cutting their losses or waiting indefinitely for something exciting to happen.
When it comes to individual funds or trusts, investors should consider whether there is a team ‘on the ground’. While not essential, it helps the prospects of the fund if it has a team in the individual country, with members who know the local market dynamic and can speak the language to seek out under-researched firms.
According to Yearsley, you should also take into account how ‘mainstream’ any specific country is. ‘I think you need to distinguish between emerging markets such as India and China and the more frontier-like ones such as Pakistan and Indonesia,’ he says. ‘The latter frontier markets are too risky in my view to hold as single-country funds, as they can easily be the best or worst performers for many years in a row.’
How to build your portfolio
Krishna Kumar of Eastspring Investments is very bullish on Asian emerging markets and the prospects they offer, particularly riskier, more esoteric markets such as Indonesia and Vietnam. Despite this bullishness, however, he urges caution. ‘Investors may want to invest a small amount rather than going all-in,’ says Kumar.
According to Yearsley, ‘the maximum you should have in emerging markets generally should be 10-15 per cent.’ Within that, he recommends not having more than 2 or 3 per cent in any one emerging market or specific emerging market fund.
Investors should also think carefully about how they plan to gain access to a particular country. China and India, and to a lesser extent Vietnam, have seen a proliferation of interest in country specific active funds. But for other emerging markets, it’s a different story.
For instance, both South Korea and Taiwan are home to some of leading firms in the world. However, a country-specific active fund or trust in either of these economies makes less sense. In South Korea, Samsung makes up 28 per cent of the index and the tech sector comprises 37 per cent, while in Taiwan, Semiconductor makes up 22 per cent of the Index while tech companies account for 56 per cent. The concentrated nature of each economy reduces the effectiveness of active management. Anyone attempting to access each market on its own would arguably be better off with an ETF or a broader fund which includes each economy as part of a wider portfolio.
Likewise, investors should be aware of the sort of firms favoured by any country-specific fund they are investing in. Despite strides taken by Brazil in developing a consumer economy, energy and commodities are still an integral part of its economy and so are likely still to be a major component of a manager’s portfolio. BNY Mellon Brazil Equity, for instance, has just under 11 per cent in oil & gas and another 12.8 per cent in industrial metals and mining.
If a country-specific fund is dominated by commodity- exporting firms, you may not necessarily be investing in emerging market growth, but primarily in the boom and bust cycle of the energy and natural resources sectors.
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