Emerging markets -- hung out to dry in recent years.

Ten years into my hardcore investing obsession, I’m still surprised how predictable investors can be.

Take the cycle of fear and greed, for example, and put emerging markets in for spin.

A few years ago you’d get shouted down if you suggested that unloved US and UK equities might be as good a home for your money as emerging markets.

Yet now the average investor doesn’t want to touch emerging markets with a barge pole. [Note to editor: Please insert witty comment about the indigenous boat people of an exotic island nation here.]

There are doubtless multiple reasons why emerging markets have done poorly for the past two or three years. Pundits point to inconsistent economic growth, stifled reforms, political risk, lower commodity prices, and the end of easy money.

To my eyes, though, optimism and pessimism has played its usual starring role – expressed as ever through the valuation put on traded assets like shares.

Emerging markets can go down as well as up

Immediately after the financial crisis, the West was in the doghouse while emerging markets powered ahead. Our shares were cheap on various metrics, theirs were arguably expensive.

Myopic investors made giddy by recency bias assumed this state of affairs would continue forever.

They also ignored warnings that economic growth was not a predictor of stock market returns – basically because anyone can see when a particular country is booming by reading the newspapers and watching the news.

So by the time the average investor – whether professional Gordon Gecko type or enthusiastic oik like us – arrives at a promising scene, the party is in full swing.

If you arrive late, you pay a high price to be part of the in-crowd in terms of the P/E multiples and price-to-book ratios you pay for your shares. That leaves little wiggle room for future disappointments – and sometimes mediocre returns even if things go as planned.

Beaten by the ‘broken’ USA

Since then the mood has soured on emerging markets. Yet all the problems they are said to face today existed when everyone loved them, too – at least on a longer-term perspective – as well as the opportunities.

To me, that makes emerging markets a more attractive place for my money, rather than less so.

If you’re a smart passive investor, you probably already have an allocation to emerging markets. Take this article as simply saying that when you come to rebalance your equity holdings and see that your emerging market index fund is down, hold tight and top up.

Smile inwardly! What goes around comes around. That’s exactly why you’re rebalancing, in fact.

As for us nefarious active investors, the pessimism could make for a fertile hunting ground, especially after double-digit gains in the developed world this year make some of them, notably the US, look more fully valued.

See how the soaraway S&P 500 has trounced emerging markets in 2013:

S&P 500 versus iShares Emerging Markets ETF (EEM)

S&P 500 versus the iShares Emerging Markets ETF (EEM)

The S&P 500 has beaten the iShares emerging markets ETF by more than 30% in the year to-date.

Will that stellar level of outperformance continue?

Maybe.

Will it be replayed every year for the rest of the decade?

I’ll go out on a limb and say: Not on your nelly.

We’re all in it together

The extreme case made for loading up to the eyeballs in emerging market shares never made much sense to me, even when they were doing well.

Yes, the citizens of emerging nations are mostly younger than us, and they have faster growing economies. But we were (and are) the wealthy ones, and we have plenty to sell to them, too.

The UK FTSE 100, for example, generates more than 70% of its revenues from overseas. UK consumer goods giants like Unilever (Dove, Bovril, Marmite) and Diageo (Johnnie Walker, Baileys, Guiness) get a huge proportion of their sales directly from emerging markets.

For this reason, even if the UK and US economies were doomed to decades of stagnation or worse – which I doubted then and now – it might be different for our listed companies. Not for nothing do critics of Western capitalism paint them as rapacious locusts scouring the globe for profit.

Besides, I believe the truth is a less sensational halfway house.

Western economies will grow, probably a little more slowly than in the past, and our companies will likely keep a (shrinking) technical edge over most emerging rivals. But the latter will have strong domestic demand to easily tap into.

Emerging markets as a whole will be volatile, and some will utterly disappoint, whether for economic reasons or because they’re taken out in a military coup. Or some lesser evil.

By diversifying and dripping in money over time, you’ll be able to dilute the duds and profit from those markets that – well – emerge!

Emerging market investment trusts

For my part, for 6-12 months I’ve been increasing what was a too-small allocation to emerging markets. Mainly by fiddling about with my index fund allocations but also by buying shares in relevant investment trusts.

So far it’s not been wildly successful, but this is long-term money that I add to piecemeal.

In addition, I own a couple of family-run global investment trusts that have floundered in part due to their emerging market exposure, particularly RIT Capital Partners and Hansa Trust. (The latter is mainly an idiosyncratic bet on Brazil and other emerging markets, though you might not realise that at first).

I have also put more money into companies hurt by their association with emerging markets, such as Unilever when it fell below £23.50.

When I scan some of the emerging market investment trusts, I do wonder if I should be bolder. That’s because fear and greed is doubly captured in the discounts they can trade at to their assets.

Here’s a few I’m mulling over:

Ticker Discount/
premium
Yield YTD1
Aberdeen Asian Income AAIF +1.6% 4.0% -12%
BlackRock Latin American BRLA -10% 5.4% -19%
JP Morgan India JII  -15.5%  n/a -10%
Hansa Trust HAN -26.7%  2.0% 16%
Templeton Emerging Markets TEM -9% 1.2% -9%

Sources: AIC Stats for trust data and Google Finance for year to date returns.

Please note that I’m not recommending the trusts above as good buys. I don’t give advice, and you will need to do a lot of research yourself.

These are just a few of the trusts that I’ve been considering. In some cases there are definitely reasons to be wary (such as an uncovered dividend in one instance).

Finally I’ve even boldly gone beyond the pale, to Frontier Markets. Only a smidgeon invested in that, but it’s doing okay so far. It’s one for the very long-term.

Not every emerging markets investment trust looks cheap. JP Morgan Emerging Market Income (Ticker: JEMI) is on a small premium, as is Aberdeen Asian in the table above.

I suspect in today’s yield-hungry world, a 4% dividend yield trumps even fear!

For all the bulls in China

I am not claiming to have called the bottom for emerging markets, or anything like that2. You could imagine them falling much further from grace, especially if investors weren’t being pacified by strong returns elsewhere.

But I do think they look shunned and therefore worth an extra poke.

You might be surprised how quickly sentiment can change. Fidelity China Special Situations (Ticker: FCSS) is a case in point.

  • In summer 2013, FCSS reached a low of 81p and the discount surpassed 11%.
  • Now they cost 105p to buy. That’s a 30% rise in just five months.

I’m not saying (of course!) that it’s easy or sensible to look for quick returns like that. I’m suggesting it’s a better time to buy and lock away this asset class for the long-term than it was just 2-3 years ago.

Still, the sudden reversal of opinion about China is an excellent example of just how fast people can change their minds about a particular emerging market – and how rapidly it can be reflected in share prices.

  1. Year to date.
  2. Especially as I’d be late on current evidence – they seemed to touch base a few months ago.

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