How to invest in emerging markets

Readers may have seen an article written by Tony Featherstone in Fairfax media this morning entitled ’10 tips for investing in emerging markets’, which, as you might suspect, offers useful advice for investors in emerging markets.

As with many ‘one-size fits all’ lists of tips, reader mileage may vary, so I’ve offered alternatives which may be more suited to certain investors:

1) Asset Allocation

Mr Featherstone argues that investors should have only a fraction of assets invested in emerging markets, and conservative investors who can’t withstand volatility should avoid these assets. According to quoted figures, the average Australian-managed international share fund has around 5% of its assets in emerging markets.

In addition to direct assets, investors with a medium-risk tolerance or appetite for growth could consider lifting their emerging market exposure above 5% by owning ASX-listed companies, as the Australia and New Zealand region is forecast by accounting giant EY to be among the slowest growing economies in the Asia-Pacific over the next few years.

Companies like Coca-Cola Amatil Ltd (ASX: CCL) have ample opportunity to use their capital and expertise to grow overseas, though it must be noted, Amatil itself still earns the vast majority of its money in Australia.

2) Investment Horizon

Mr Featherstone recommends taking a 7-10 year view, which is crucial in volatile markets to help smooth out volatility and price swings.

A sound recommendation, although readers should note that investing for the long-term heightens the chance of being stung by typical ‘emerging market stuff’ like legislated wage and holiday increases and difficulty of doing business. It also allows companies to build an effective brand as well as grow productivity and influence which should not be understated.

3) Know what you are getting

This is a vital recommendation. Many ETFs and funds are heavily focussed on certain areas, despite appearing to have a broader focus. For instance, the Vanguard FTSE Emerging Markets Shares ETF (ASX: VGE) is heavily focussed on China (21%), Brazil (18%), Taiwan (13%), and South Africa (9%) at present. The Emerging Markets Masters Fund (ASX: EMF) is heavily focussed on China, Brazil, Latin America, and Eastern Europe.

Even more critically, investors should look into what exactly those percentages are comprised of. As 21% of China sounds great, but if most of that is in heavy machinery and steel smelting businesses, you’re unlikely to achieve decent returns. Even our own S&P/ASX 200 (INDEXASX: ^AXJO) (ASX: XJO) index is heavily focussed on finance and resources, which are cyclical industries.

4) Consider narrowing your exposure

Investors with a particular investing thesis, such as wanting to target South-East Asia or China, might be better served by choosing a fund or ETF that focusses specifically on these regions, excluding areas that the investor is not interested in such as the Middle East, Eastern Europe, or Latin America.

5) Take a fund approach

Diversify by using a fund manager that provides exposure to a basket of companies across several countries.

While this point appears to contradict #4, when taken in combination with #6 below I believe Mr Featherstone means that investors should lean towards using fund managers rather than doing it themselves. Certainly a fund manager can devote more time and resources to research – and is presumably more skilled – than the average investor.

6) Choose active over index funds

Mr Featherstone argues that an active fund can limit losses during market crashes, and is worth the higher fees.

Certainly an active fund manager should deliver better overall performance in return for their higher fees, and you should aim to come out ahead of an ETF index fund if you use one. However, earlier points already established that emerging markets are best kept as a small part of your portfolio and only for investors with some appetite for risk and a long-term time frame.

A fund manager that sells the lot when the market crashes might not be compatible with your long term, risk tolerant investment strategy. If you can, find out how the fund you use handles periods of market volatility. Also make sure your performance is worth the fees, as an extra 1% in fees can cost literally hundreds of thousands of dollars over several decades.

7) Consider other approaches

For example, owning US or European companies that have operations in China, India, or other target markets.

This ties in with my Coca-Cola Amatil reference above, and it’s increasingly easy for Australian investors to get exposure to emerging markets through ASX-listed businesses like Carsales.Com Ltd (ASX: CAR), A2 Milk Company Ltd (Australia) (ASX: A2M), iCar Asia Ltd (ASX: ICQ), Blackmores Limited (ASX: BKL), Macquarie Group Ltd (ASX: MQG), and many more. Investors also enjoy relatively higher company quality, oversight, analyst coverage, and disclosure compared to many in emerging markets.

8) Know what the fund owns

Tying in with number 3 above, this is absolutely critical. While you may not have the skills to identify good or risky businesses, you can at least look at how many are in what sector of the market. An over-concentration on resources or financial stocks, for example, might be a red light for your investment.

9) Currencies

Find out what currencies your fund, ETF, or company earns its money in, and whether it has any hedging strategies to mitigate the effects of currency fluctuations.

Many funds provide indicative statements saying ‘a 5% rise/fall in the AUD against the XYZ would impact our profit by A$___ million’ and these are always worth a read. Also consider that as a long-term investor in emerging markets, your priority is likely to be growth more than currency movements.

Coca-Cola Amatil’s Indonesian segment has been smashed in recent years as a result of currency movements and legislated wage increases, yet the business itself is growing sales volumes very rapidly.

10) Assess the manager

Quoting Mr Featherstone directly, ‘What is the manager’s reputation, past performance, and investment style? What are the fees? Does the manager have a long record of investing in emerging markets and people on the ground in those regions? Emerging markets require specialist investment skills acquired and developed over time.’

Like much of the rest of the article, this is a great recommendation, especially the emphasis on people on the ground. Investors can gain enormous insight into a company’s prospects in a given market by working and living in that region for a while.

11) Bonus tip

One bonus tip from me. Australian government employees from the Department of Foreign Affairs and Trade (DFAT) produce reams and reams of information on the business opportunities, trade practices, and legislative environment in many of our trade partners, such as Thailand. Reports from the World Bank and International Monetary Fund (IMF) are also worth checking out, and much of the information there is sufficient to soothe many common fears of investing into emerging markets.

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Motley Fool contributor Sean O'Neill owns shares of Limited, Coca-Cola Amatil Limited, and iCarAsia Limited. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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