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Why it pays to be active in emerging markets

Why it pays to be active in emerging markets

One of the first decisions any investor has to make is whether to invest with an active manager or seek to track an index. This is no different for emerging markets. However, we believe the decision is more complex for emerging markets, which have a number of idiosyncratic characteristics. Investors need to take this into account when making a choice.   

The factors that influence the performance of emerging markets are often as much about external events as they are about internal events, and this is important when considering how to invest. Emerging markets will go up and down depending on what is happening globally as much as their domestic situation. For example, the global financial crisis had profound effects on emerging markets, even though it was largely a developed markets problem.

There is no question that these markets are more volatile than developed markets - around 1.5x, although there is some variance around that in individual markets and stocks. There are clear reasons for this: turnover is lower in most stocks. Equally, the free float for most emerging market companies is around 30-40% compared to 60-70% for developed markets. The free float is the number of shares available for sale to private investors, as opposed to – for example – company executives, or the government. Lower turnover and free float means that a pound going in and out has a greater impact on the share price of an emerging market company.

When examining net inflows into emerging markets, the money taken to move these markets up and down is not particularly large. These markets are driven by global investors because most do not have a well-developed domestic investor base. This means greater volatility because foreign investors will be influenced by sentiment in their own markets. These are technical markets and as investors, we need to be conscious of how flows can influence share prices and act accordingly.

Another consideration for investors deciding between active and tracker funds is that the indices on which tracker funds are based change all the time, and they have changed quite significantly in recent years. From 2010 to 2017, there has been a substantial increase in technology – by 30-40%. There has also been a substantial decrease in commodities, for example, and an increase in the weighting towards China over the period. When people talk about emerging markets, they suggest it is a warrant on global growth, but in fact the cyclical elements have been a declining force for some time in emerging market indices.

These changes have occurred because emerging markets are far more dynamic than developed markets – new companies come in, regions move in and out of favour. One of the big differences between emerging and developed markets is that in emerging markets, stock markets are still considered a way to raise capital. New companies are coming to the market all the time and there is a lot of dynamic change.

Perhaps more worrying for passive investors would be the increasing exposure to China within indices – it is now around 30% of the MSCI index and likely to increase - at the same time as the country appears to have heightened risk. Debt is rising, and the main component of that debt is the corporate sector. This is a concern – particularly as economic growth is slowing and with it, the ability to service that debt. While there may be no imminent danger, a tracker fund cannot make an active call on the right time to exit.

State-owned enterprises remain some of the largest companies within emerging markets. To our mind, these companies have a conflict at their very heart – who do they work for? The government or minority shareholders? Many are less profitable as a result. A key example might be Chinese banks, where – in spite huge growth in loans in China - yields have come down substantially. The relative weakness of some of the large companies in the indices needs to be taken into account when running an emerging markets portfolio.

Governance has been improving in emerging markets, but there are still lots of issues. In emerging markets, there is typically a controlling shareholder – either the state or a family - and investors need to make sure they are on the same side, because often they are not. In addition, there is a danger of related party transactions and investors may not be achieving the diversification they think they are. There are fewer checks and balances in emerging market companies, particularly at board level, and the information that available to make decisions can be less transparent.

These issues all need to be considered when investing in emerging markets. As an asset class, it has high potential rewards, but it is also more volatile, more changeable, there is more state ownership and there are still governance issues. In our view, this necessitates an active approach to picking companies and markets rather than simply tracking an index.

Aberdeen is one of the leading active managers of Emerging Markets trusts. Our trust range incorporates general emerging markets trusts, such as the Aberdeen Emerging Markets Investment Company Limited, but also more specialist trusts, such as Aberdeen Frontier Markets Investment Company Limited, Aberdeen Latin American Income Investment Company Limited, Aberdeen New India Investment Trust PLC and Aberdeen New Thai Investment Trust PLC, helping investors to take selective exposure to the region.

RISK WARNING

The following risk factors should be carefully considered before making an investment decision:

  • The value of investments and the income from them can go down as well as up and you may get back less than the amount invested
  • Emerging markets or less developed countries may face more political, economic or structural challenges than developed countries. This may mean your money is at greater risk

Find out more at:

www.aberdeenemergingmarkets.co.uk

www.aberdeenfrontiermarkets.co.uk

www.aberdeen-newindia.co.uk

www.latamincome.co.uk

www.newthai-trust.co.uk

 

This article was provided by Aberdeen Investment Trusts and does not necessarily reflect the views of Citywire

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