Passive investing has become increasingly popular over the past 10 years, thanks to the lower costs that it offers – and overall returns that often end up comparable to active investing.
While fund managers will tell you that their expertise can help beat the market, on average they don’t and the difficulty of spotting who will succeed in advance has compelled more investors to take the passive investing route of just tracking an index.
But while index funds might be a great option if you’re tracking a very broad global index, or a well-researched market where it’s hard for managers to gain an edge, such as big UK or US company shares, there’s a big question mark over their value in trickier places such as emerging markets.
Investing in emerging markets through an index-linked fund might not be that low risk
Despite those concerns, over the past two years, investors have increasingly sought exposure to countries including China, India and South America by buying passive funds that track an index such as the MSCI emerging markets index, which covers large and mid cap companies in 24 emerging markets.
Figures published earlier this year showed exchange-traded funds tracking emerging market assets now represent almost a fifth of total emerging market fund assets – up from over a tenth just two years ago.
There is good reason for this. If you’d invested £1,000 in the iShares Core MSCI Emerging Markets ETF five years ago, it would be worth just shy of £1,400 today, thanks to a 38 per cent total return.
That falls short of the top performing active fund, Hermes Global Emerging Markets, which has racked up a 85.7 per cent gain over five years, but it is enough to beat 33 of the 67 emerging markets funds with a five-year track record, according to FE Trustnet data.
Investing part of your portfolio in these funds might be good for diversification but there is a downside: emerging markets are typically less regulated and can be volatile and unpredictable.
In an index fund you are fully exposed to any market falls. An example of how this could hit is that if, on the other hand, you’d invested mid-2015 and sold out a year later, you’d have lost around a fifth of your money after the market dived 20 per cent.
The sharp drop in the MSCI emerging markets index in 2016 was largely down to China, which dominates the index along with South Korea, and it highlights why investing in emerging markets through an index-linked fund might not be quite as low risk as it might at first appear.
Over five years the iShares Core MSCI Emerging Markets ETF is up 38%, but there was a big dip for investors in 2016
What makes emerging market trackers riskier?
Indices can be dominated by the largest companies within them. For example, HSBC makes up 7.6 per cent of the UK’s FTSE 100.
A large number of companies in the emerging market index are Chinese-listed state-owned enterprises and internet businesses with complicated ownership structures that offer foreign minority shareholders little or no legal protection.
This state control can sometimes lead to poor outcomes for shareholders. For example, there are several Chinese companies involved in the country’s One Belt and One Road policy. This has ambitious infrastructure and economic aims, hoping to better connect China with other parts of Asia, Europe, East Africa, the Middle East and Russia.
Such global ambition requires unbounded amounts of capital, with estimates ranging from $4trillion to $8trillion. But while building and infrastructure development are able to consume such colossal amounts of money, it’s less certain that the state-owned firms investing in them will produce a positive return on equity for shareholders.
The table and map above shows how the MSCI Emerging Markets index is weighted to different countries
Is there evidence for this?
The state-owned Zhongda China Petrol, for example, recently completed an oil refinery in Kyrgyzstan, Central Asia. When built it could only run at 6 per cent capacity because it could not source enough oil.
Even privately-owned companies listed in China present problems for investors.
Chinese internet firms Tencent and Alibaba have delivered huge growth in recent years, but in spite of having no official influence over these companies, the Chinese government has legislated in such a way that foreign investors have no legal right to the companies’ underlying assets.
What would a fund manager do to manage this risk?
Finegan : I want to avoid investing alongside any crooks
Glen Finegan, head of global emerging markets equities at Janus Henderson Investors, has warned that parking your money in an index fund in emerging markets can be dangerous.
‘In the global equity space there are a lot of very high quality companies with long track records where you can have a high degree of confidence that in many cases governance structures are there to protect you,’ he says.
‘The emerging market is something different. Many companies exist simply for society’s enrichment or purchase of national service, and when you look at the index it’s full of these types of companies.
‘These companies may have big market caps but there’s not necessarily any evidence that they exist to create wealth for foreign shareholders,’ warns Finegan.
‘As someone who thinks firstly about capital preservation I want to avoid investing alongside any crooks who might be investing in some of these companies. So we start bottom up and build all our portfolios from a blank sheet of paper.’
Finegan’s fund – Janus Henderson Emerging Markets Equity and International Opportunities – limits its exposure to China to between 4 and 5 per cent. It yields 1.4 per cent and has ongoing charges of 0.95 per cent. Over five years it is up 35.5 per cent.
It is possible to buy country-specific ETFs, such as those investing in India. But investors must be aware that putting even a relatively small amount of their portfolio in, can skew them heavily towards it compared to the global market
Do any trackers balance these risks?
Choosing an actively-managed fund that avoids mimicking the index is one way to limit your exposure to state-owned enterprises, but these funds are typically more expensive than trackers and some investors want low-cost options.
A couple of simple and broad market cap weighted emerging market index funds are the iShares Core MSCI Emerging Markets ETF and the HSBC ETFS Emerging Markets ETF, or for those who prefer tracker funds, the iShares Emerging Markets Equity Index fund.
Richard Flax, chief investment officer at Moneyfarm, explains that there are passive funds that take account of the issues raised by Finegan.
‘For those who don’t want a simple market-cap weighted ETF, there are passive alternatives such as those focused on specific regions or sectors, socially-responsible or high dividend paying companies,’ he says.
‘Political and governance risks in specific countries and sectors are usually more relevant for emerging markets investing than in the US or UK – even for companies that may not be directly state-controlled. This argues for the benefits of diversified exposure, such as through a low-cost ETF.’
If you’re looking for a tracker fund that invests in emerging markets but doesn’t simply track the MSCI index by market cap, there are funds available.
For example, the UBS MSCI EM Socially Responsible ETF uses a screen for the companies it invests in based on specific values such as religious beliefs, moral standards or ethical views. It has an annual management fee of 0.53 per cent.
The iShares EM dividend ETF meanwhile tracks an index of those companies with higher paying dividends in emerging markets and has an annual management fee of 0.65 per cent.
The iShares EM small cap ETF provides exposures to small public companies in emerging markets and charges an annual management fee of 0.69 per cent.
There are also whole host of country specific ETFs that you can invest in, although you need to be aware that many emerging markets companies only make up a small chunk of the global market. The more you shift away from that weighting, the more you expose yourself to their fortunes. (Learn more about this in What’s in a global ETF?)
So, for example, while you might consider that putting 10 per cent of your portfolio into India does not skew you too much towards its fortunes, this matches the entire allocation to developed and emerging Asia in the global market iShares MSCI ACWI ETF, which holds about 1.2 per cent of the fund in India itself.
Costs on more specific ETFs and trackers can be higher.
Five funds for emerging markets
Darius McDermott, managing director of Fund Calibre, picks five funds he believes offer promising returns from emerging markets.
We think that emerging markets are a good long-term investment. They are still reasonably fair value compared with their own history and, if you compare with developed markets – which are on the pricey side right now – they definitely look cheap. It’s all relative.
The North Korea situation is a worry for Asia (all of us) so the uncertainty of how that will pan out is likely to have a short-term impact on their stock markets.
But if that is resolved successfully, South Korea is actually looking good as an investment opportunity, as corporate governance is improving and the government is actively looking for positive change.
South East Asia – and namely ASEAN countries – is also looking better now the dollar has fallen slightly.
Frontier countries that are moving towards being emerging (or have just made the grade) like Bangladesh and Pakistan could also do well as they have momentum behind them.
We’re long-term fans of India and that view has not changed. It has great demographics, an entrepreneurial society and, with Modi in power, some political stability and power to make the changes needed to infrastructure and red tape.
Latin American doesn’t look so good. Venezuela has had a bad time, as has Brazil on the back of a second impeachment.
Yield: 3.4 per cent
Ongoing charges: 1.43 per cent
This fund offers exposure to emerging market companies that pay higher-than-average dividends – often in niche areas, which may be overlooked by less well-resourced teams.
A hidden gem among other better known emerging markets funds, it benefits from a strong team, an intuitive investment approach (focused on finding the best companies, rather than predicting market or economic trends), and the backing of a company with many years of specialist experience.
Yield: 0 per cent
Ongoing charges: 1.21 per cent
This is a relatively new fund, launched in January 2016. But the 16-strong team has been together for a long time.
Led by John Malloy and James Johnstone, they joined en masse from Everest Capital, when the company announced that it was shutting six of its seven funds, leaving its highly respected emerging- and frontier-markets team looking for a home.
We like this fund as it ventures into the frontier market space too and the portfolio therefore looks very different.
Yield: 2.1 per cent
Ongoing charges: 1.14 per cent
This is an emerging markets equity income fund run by a team that has been together for 15 years, with a good track record. The fund predominantly invests in large companies, but still manages to have quite a different make-up to its benchmark.
Yield: 0 per cent
Ongoing charges: 1.17 per cent
Run by the charismatic Gary Greenberg, this is another great fund that is more macro driven than the others we have listed.
It relies on the manager getting his calls right, but he has done this pretty consistently over the years. He has a good, clear process and looks at environmental and social considerations as well as economic ones.
Yield: 1.4 per cent
Ongoing charges: 0.95 per cent
This fund has been run by Glen Finegan since 2015.
He joined from the First State Stewart Global Emerging Markets teams – one of the most successful in the industry – so his credentials speak for themselves.
A key part of his process is preserving capital, which can be very important when it comes to emerging market investments.