How to capture emerging dynamism

For many investors, buying into the superior growth story of emerging markets has been anything but compelling over the past three years.

The average China fund, for example, has returned a big fat zero over three years – an underwhelming return that also extends to the average performance of diversified emerging markets funds.

Nevertheless, a glance at our investment trust and fund awards this month and last month shows there have been plenty of opportunities to make very strong gains – up to 150 per cent after three years in one instance. Successful emerging markets strategies have focused on income, smaller companies and specialised areas such as infrastructure. Such strategies could just as easily fall out of favour, and income, particularly Asian fixed income, has recently been hit hard as investors fret about growth and talk of an end to cheap money via quantitative easing. 

However, while investors who focus on short-term trends de-risk their portfolios by fleeing Asian and other emerging markets, this could also be the right time for longer-term private investors to increase their allocations. But what to buy? Many of the best funds and trusts are now too expensive. Trust share prices now stand at a premium to net asset value, while sought-after funds apply mandatory initial charges to discourage new money. 

What about the index-tracking route? Trackers may be cheaper than most actively managed funds, but unless you are seeking specific country or regional exposure, you might not get what you thought you were paying for. 

Take the MSCI Emerging Markets index, which tracks 19 countries, weighted by the size of their stock markets. This index favours larger and potentially less dynamic countries such as South Africa and Korea. With China, Brazil and Taiwan, they represent nearly two thirds of it. In contrast, the Philippines – which by 2050 is forecast to have twice as many people as the UK and should have enjoyed a nine-fold rise in purchasing power – represents just 1 per cent of the index. Essentially, the economic dynamism of smaller emerging markets is not reflected in market-cap weighted indices such as this.

Enter the new emerging markets index-tracking fund from Sarasin & Partners – Sarasin IE Emerging Market Systematic. This Dublin-registered fund aims to capture true emerging markets performance by equally weighting all 19 constituents of the MSCI Emerging Markets index. 

The strategy is based on the concept of ‘mean reversion’, which has worked particularly well in emerging markets because of their high volatility and low correlation with other asset classes. To achieve this the fund rebalances each country to an equal weighting every month by selling the winners and buying the losers.

Paul Cooper, a partner at Sarasin, claims the fund is capturing ‘smart beta’, and academic research backs the regular rebalancing act. Sarasin has run a similar fund in Switzerland since 1996 that has consistently outperformed the MSCI Emerging Markets index. The recent three-year comparison is shown in the chart above – it does not account for annual management charges, which could be as high as 1.5 per cent. 

The way the fund achieves this is not as expensive or risky as first appears. First, it has no physical exposure to the markets it tracks. Instead, it engages in monthly transactions with investment banks to provide the desired exposure, via derivatives known as unfunded swaps. 

Using unfunded swaps means cash remains in the fund, where it is used to buy short-term US Treasury bills or cash-like equivalents. So cash needed to deliver index underperformance back to the counterparty investment bank is easily accessed. And because each swap is reset whenever a profit exceeds 2 per cent, any counterparty risk is effectively neutralised should the investment bank fail to deliver on its side of the bargain.

There is always a place in an emerging markets portfolio for actively managed funds and trusts. But the Sarasin fund’s novel approach is capturing a far wider range of dynamism in developing countries than other popular emerging market index trackers.

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