Beware of emerging markets

By BRENT SHEATHER



Every 10 years or so emerging markets seem to flash on to local investors' radar screens, but if the 1.3 per cent per annum performance of the IFC index during the past 10 years is any guide, it is unlikely that too many locals have got rich through this asset class.

While today the sector's performance looks uninspiring, it hasn't always been so.

In the heady days of 1994, when two closed-end emerging markets specialist funds run by industry leader Templeton and British manager Foreign & Colonial listed on the NZ stock exchange, the IFC index boasted a return of 42 per cent in 12 months.

The future was looking bright. Unfortunately that was more than priced into the market and the premium at which closed-end funds traded to their asset value left no room for unexpected disappointments such as Asian crises and currency meltdowns, not to mention widespread fraud at the corporate level.

Back then, this writer bought the high-growth, high-profit story and even today, 10 years later, his 1000 Foreign & Colonial Emerging Markets shares are still down about 50 per cent on cost.

However, every dog has its day: a recent report on the attractiveness of emerging markets by America's largest fund manager, Vanguard, gives the sector a guarded endorsement. (The more people who know about it, the better the chances of getting that Foreign & Colonial Emerging Market position back to break even).

The Vanguard study predictably concludes that the allocation of a portion of a portfolio's international exposure to emerging markets can enhance its long-term, return on the basis that the higher GNP growth rates of emerging markets countries will translate to higher profits and thus share prices. Nothing too extraordinary there, but Vanguard is unique among fund managers in that it feels obliged to elucidate not only the upside of an investment strategy but also the not-so-good points. Indeed, Vanguard resisted the temptation to roll out technology funds in 1999 and, when everybody was buying growth in 2000, it floated a value fund. Coincidentally, Vanguard is not privately owned but is instead a mutual fund in that it is owned by its unit holders.

Vanguard's research analyst, Dr Yasim Tokat, sets out disadvantages of emerging markets investing.

Firstly, because they are particularly volatile, an investor needs to have a genuinely long-term horizon of 10 years minimum. This is illustrated by the Thai stock market falling 87 per cent over 1996-97, a bit of a setback if you were two or three years from retirement.

Financial theory says that, again in the long run, higher risks should mean higher rewards, but Vanguard points out that there have been extended periods where emerging markets have dished out negative returns and high risk.

There is also a good chance that some emerging markets will never emerge, even over a lifetime. Vanguard cites the example of Argentina which, in 1913, had a greater GDP per head than Germany yet 90 years later it continues to disappoint and its GDP is now half Germany's.

Second, Vanguard highlights the high cost of investing in emerging markets, in terms of the higher management fees that such vehicles typically charge and the cost of dealing in typically illiquid markets.

This last point is particularly relevant if your fund manager trades his or her portfolio frequently as brokerage charges are often double those in developed markets and the spread between buy-and-sell quotes also tends to be extreme.

Vanguard also notes that the correlation between emerging markets and developed markets has increased in recent years, reducing diversification benefits.

Perhaps the most compelling case for buying an emerging markets fund right now is that the stocks look cheap. Mark Mobius, the Indiana Jones of the savings industry and long-time emerging market manager for Templeton, says that at June 30 the average price of the NZ-listed Templeton Emerging Market fund portfolio was around 11.5 times earnings and the dividend yield was about 3.5 per cent, considerably more attractive than the same measures for developed markets.

"We remain optimistic that the management of emerging market companies will increase their cash dividends, partly because of earnings growth and partly because of higher dividend payout ratios."

As well as setting out the theoretical case for emerging markets, Tokat gives advice for implementing the strategy and notes that traditional asset-allocation theories suggest the investor should have a significant allocation to emerging-markets equities, behavioural and practical considerations call for a smaller allocation.

Thus the news is not good for incumbent Foreign & Colonial Emerging shareholders: Vanguard reckons a risk-tolerant investor should allocate, at most, 3 per cent of assets to emerging markets.

Applying this to the average retired or soon-to-be-retired New Zealand mum and dad probably means that specialist emerging market trusts are about as relevant as technology or internet funds.

Furthermore, if mum and dad already own a broad-based international equity fund, that vehicle probably has the requisite emerging market exposure.

So investment in specialist funds like Templeton and Foreign & Colonial is probably best left to institutional investors who wish to overweight the sector by the 1 per cent or 2 per cent that their investment mandate permits, or speculators who acknowledge the higher risk but can afford to have a go.

Mum and Dad Battler should probably sit this one out.

* Brent Sheather is a Whakatane investment adviser.