Taking a closer look at emerging markets

Have the Olympics and Paralympics inspired you to take a fresh look at Brazil – and global emerging markets more generally? If so, there’s an obvious question to ask: is the remarkable recovery we’ve seen from these markets during 2016 sustainable?

It has certainly been quite a turnaround. Emerging markets fell sharply in each of the past three calendar years; by contrast, in 2016, the MSCI Emerging Markets Index rose by 13 per cent during the first eight months of the year. Add in the effect of the precipitous fall in the value of sterling we’ve seen since the Brexit result and UK investors are sitting pretty -  the average open-ended global emerging markets fund made a return of 28 per cent over the year to the end of August but investment companies have done even better; the typical closed-end fund in the sector returned almost 33 per cent.

The debate now is whether the good times can continue. Do positive market drivers, including improving commodity prices, lower global interest rates and the long-term demographic advantages of emerging markets, outweigh risks such as political instability, the potential for the commodities markets to stall, and issues with infrastructure and public sector dependence?

That’s a difficult call to make, but it is worth reflecting on one thought: 85 per cent of the world’s population live in an emerging markets and these developing nations collectively account for 50 per cent of global economic output. In other words, any diversified investment portfolio that doesn’t include some emerging markets exposure does not reflect the realities of the world we live in.

For many investors and their advisers, the sensible approach is going to be to allocate a smallish chunk of the portfolio to emerging markets – say 5 to 10 per cent – possibly using regular savings plans that can help take the sting out of day-to-day market volatility.

Investment companies represent an excellent way to do exactly that, for a number of reasons. In practical terms, most emerging markets-focused investment companies offer a low-cost regular savings scheme to enable people to drip-feed money into their funds; there’s also a good choice of funds, with around a dozen investment companies to be found in the global emerging markets sector alone.

Closed-ended funds also have some structural advantages that can be particularly important to emerging market investors. On the upside, they have the ability to take on gearing to enhance returns in a rising market, plus you tend to get a benefit from a narrowing in the discounts at which funds’ shares trade relative to the value of their underlying assets. Both these attributes have helped global emerging markets investment companies eke out a significant lead over their open-ended peers over the course of this year.

On the downside, moreover, investment company managers don’t have to contend with the problem of fund outflows if investor sentiment turns negative. Open-ended fund managers, by contrast, may find themselves having to sell assets to fund investor withdrawals, often at just the moment in the markets when that’s what they don’t want to do.

Emerging markets remain risky, of course, and only make sense on a long-term view. But for advisers and investors who want long-term exposure to the undoubted growth potential of these developing economies, it’s definitely worth considering an investment company.