Investing in emerging markets (EMs) can be fraught with extra risks. Money Management speaks with EM specialists on how they navigate this challenge in their day-to-day fund management.
Political turmoil, the threat of war or geopolitical risk, less transparent practices than developed markets and businesses owned by the state are some of the issues that can arise when investing in the 24 EM countries, led by the largest constituents China and India.
Practices around environmental, social and governance (ESG), which are a key issue in developed markets, are also often less prominent due to a lack of data or a reluctance to disclose the information to shareholders, although it varies by country. This can be problematic if the fund management firm has strict ESG policies in place for their investments.
Nevertheless, many investors and fund managers are willing to accept this as there are strong returns up for grabs for those who are willing to take the extra risk. There is also the chance to get in early on countries that are later upgraded from EM status to developed market (DM).
In MSCI’s 2023 annual market classification, for example, it announced it is considering upgrading Korea from EM status while warning that frontier markets Kenya, Bangladesh and Sri Lanka are experiencing market accessibility issues.
According to the International Monetary Fund’s (IMF) World Economic Outlook for January 2024, advanced economies are expected to see growth decline slightly from 1.6 per cent in 2023 to 1.5 per cent in 2024. Meanwhile, EMs and developing economies are forecasted to experience stable growth through 2024 and 2025 at around 4.1 per cent to 4.2 per cent.
Money Management spoke with two managers to assess how and why they chose to specialise in the area.
Dr Joseph Lai, principal and chief investment officer at Ox Capital Management, said: “Emerging markets have growing economies that possess structurally growing industries and quality businesses. As stock pickers, it is exciting to unearth the underappreciated gems in the rough that are turning into champions of the future,” he told Money Management.
At Ox Capital, the firm’s goal is focused on owning quality companies with secular growth that are trading on attractive valuations.
“A difficult trinity for most markets, but given EM valuations are so depressed, we have fertile ground to work on,” Lai added.
According to John Moorhead, head of global emerging markets at Maple-Brown Abbott, the most attractive quality about EMs is their ability to generate market-beating returns over the longer term.
“The asset class is diverse: 24 countries and about 3,000 investable (i.e. sufficiently liquid) listed companies. That diversity and the different drivers of each economy and their various development stages create abundant opportunities for active investors,” he said.
Reading between the lines
While EMs present an array of benefits in the long term, both Moorhead and Lai reminded investors of the complexities that come with investing in the asset class.
Lai said: “It takes a lot of experience to operate in this space. The ability to read between the lines and understand the nuances, and to know-how to invest through the economic cycles which can be more volatile than that of developed markets [is crucial].”
Moorhead echoed this, adding that investing in global EMs is relatively more complicated than investing in a single country DM investment strategy. For example, access to particular markets can be restricted to institutional foreign investors, such as in India and Brazil, or only to those able to access their own custody providers.
“Before permitting trading access to a particular EM, we undertake risk analysis covering – among other issues – access rules, liquidity risks, custody setup, market volatility and any environmental, social and governance risks.
“Additionally, the global nature means markets are open 21 hours each day – from Korea to Mexico – meaning investors are inevitably exposed to market risks outside local market hours,” he noted.
With EMs being more heavily exposed to geopolitical risks than DMs, this consideration consumes more time in Maple-Brown Abbott’s day-to-day operations. Recent geopolitical risks include several emerging market elections taking place this year, the ongoing war in Ukraine, US-China competition and tensions in the Gulf.
“While we could make a case that in recent years, these risks have been increasing in developed markets and investors there should also be paying attention, emerging markets have a longer history of higher levels of political interference in markets and being impacted by the interconnections of global trade,” Moorhead continued.
As a result, performing due diligence before investing in an EM-based company is vital. At Ox Capital, the firm works to understand the fundamentals of every business before they enter a deal.
“This includes the annual reports, competitors, suppliers and customers analysis among others. We are also committed to fulfilling our ESG obligations. Because we like to own quality franchises, we don’t tend to encounter a great deal of questionable practices by our companies,” Lai commented.
While the level of disclosure from EM companies still lags behind DM firms, Moorhead believes the difference is made up from an increased focus on governance structures and ownership backgrounds.
“The vast majority of companies in emerging markets are either family or state owned. Often it is the quality of these owners and their relationship with stakeholders that will drive returns. We would argue this helps emerging market investors to distinguish the forest from the trees,” he said.
Assessing future EM performance
In Ox Capital’s 2024 outlook, the specialist asset manager believes the fundamentals are in place for EMs to outperform DMs in the coming year.
Looking at the biggest drivers of EM returns, Lai said the US dollar and EM valuations are key factors to consider.
“If US cut rates and the USD falls as many predict, it is not difficult to see EM equities do a lot better from very depressed levels. EM performance in the long term has tended to outperform that of DM, the last decade has been the reverse partly because of the strong USD, so it is very interesting and perhaps prospective to see if the leadership reverses,” he commented.
In terms of specific countries, Ox Capital is currently overweight in China, Indonesia, Vietnam and Brazil. For Maple-Brown Abbott, the firm sees countries such as India and Mexico as being close to all-time highs.
“Indeed, emerging markets, excluding China, in 2023 gained 20 per cent in USD terms, against 10 per cent for emerging markets including China and 9 per cent for the ASX 200,” Moorhead said.
“In the early months of 2024, the Chinese government stepped in to set a floor under its local stock market. Provided this recovery can be maintained while other emerging markets continue the trend of improving fundamentals already in place, we believe global emerging markets look well placed for 2024.”
