What are the Challenges and Opportunities of Investing in Emerging Markets?

With different political regimes and cultural attitudes, knowing how to use your money wisely can be difficult in developing economies. Citywire brought together a panel of emerging market experts to highlight the major issues.

• Yoram Lustig, Head of Multi-asset solutions for Europe, the Middle East, Africa and Latin America, T. Rowe Price
• Roman Mayer, Global Head of Fund Advisory, UBP
• Bart van de Ven, advisor and fund selector, Accuro Wealth Advisors
• Ulrich Voss, Head of Capital markets, Tresono Family Office

With the coronavirus pandemic showing few signs of abating, the financial climate has rarely been more challenging. However, recent signs have shown that investors are beginning to return to emerging markets, following panic induced sell-offs earlier this year.

Ratings agency Moody’s reported a surge in overseas debt issuance in Q3 2020, with investors looking to gain exposure to the emerging market sector as a means of accessing greater returns. Some managers are now increasingly looking to reduce their traditional US equity allocations in portfolios, with emerging markets looking more attractive at current levels.

‘We think that US equities are rather richly valued,’ said Roman Mayer, who oversees allocations made by private clients to investment funds at UBP in Zürich. ‘We think that the breadth in the market is very low; it’s driven by a few stocks, and there’s probably more room for disappointment than for anything else. We can take parts of the allocation to US equities and pivot into an area where we have underrepresentation and we think this is domestic China. Usually, when China starts giving more credit into the economy, we see a good uptick in future returns.’

When it comes to emerging markets, Asia, and China in particular, is the overriding focus for most funds. As Mayer and the other members of the panel pointed out, countries such as China and South Korea are not truly ‘emerging’ in most senses of the word, given their global dominance in sectors such as technology and fintech. But, when it comes to the index, there are major opportunities for growth.

‘Right now, China just represents 5% of the (MSCI AC World) index,’ Mayer said. ‘We think it will continue to grow because sectors like technology and particularly domestically oriented companies are thriving, and also when you look at the progress they’ve made on capital market access, how quickly they settled with international regulations when they were introducing Stock Connect.’

In the eyes of Ulrich Voss, head of capital markets at Tresono Family Office in Cologne, the Asian continent has long had the most potential as an emerging market. ‘Our stance was always to look at Asia as it has the biggest population density and development,’ he said.

Voss pinpoints Vietnam as a market that particularly stands out in terms of untapped potential, due to the combination of a relatively large and young population, with an average age of just 25. But, unsurprisingly, it is still China that draws the most attention from investors. Because of the perceived importance of the Chinese market, many asset managers have spent considerable time and money on researching new opportunities in this area. As an example, T. Rowe Price has recently increased its focus on China’s A-share market as it has opened up.

‘We have a lot of analysts with boots on the ground,’ said Yoram Lustig, who heads T. Rowe Price’s multi-asset solutions team for Europe, the Middle East, Africa and Latin America. ‘Currently, it’s more challenging to actually get the boots on the ground because it’s more difficult to fly, but our philosophy is fundamental research. Because China has also become such an important market on its own, we are focused on taking a differentiated approach that goes beyond the “mega-cap” names commonly found in other China focused portfolios, and being flexible when it comes to investing in both onshore and offshore opportunities in China.’

Accessing opportunities within the Chinese market is not always straightforward. While progress has been made in recent years, it remains relatively opaque which is why many managers look to appoint China specialists to manage that part of the portfolio. ‘There is much more quality in China today than there was three years ago or five years ago,’ said Bart van de Ven, an advisor and fund selector at Accuro Wealth Advice in Antwerp, Belgium. ‘But it’s still a different world with its own system, its own rules.’

There are also certain risks involved with investing in equities and debt in any emerging market. Lustig highlighted that currently, one of the main downsides of investing in Chinese stocks is the uncertainty relating to the tensions between the US and China. 'I think it goes beyond just a trade conflict,’ he said. ‘It’s a race for global supremacy. Some may call it Cold War II and that will have impact on the global companies from China because countries will need to take a side.'

To negate this, Lustig believes that bottom-up security selection is necessary, providing room to react dynamically to changing global events. Active managers who invest in emerging markets also feel that incorporating environmental, social and governance (ESG) criteria into the security selection process is important, because it helps watch for key shortfalls in governance such as corruption and incorrect treatment of minority shareholders.

However, implementing some ESG factors when selecting emerging market securities can be challenging, especially when viewed through the lens of the West. ’When we invest, we don’t only have ESG integrated in the process, but also have an exclusion list to avoid some of the sectors like tobacco or, in some cases, controversial weapons,’ Lustig said. ‘But ESG can be a challenge because some countries have less of a luxury to focus on environmental factors like we have in the developed world. Sometimes, on the social element of ESG, there is more inequality in some emerging economies. We tend to think that you cannot have proper ESG under a regime which is not democratic, but it’s not always the case.’

Such challenges are inherent to investing in new growth sectors around the globe, but Lustig is bullish about emerging markets in the coming years, as a new source of income for investors. ‘Western asset managers invest a lot in emerging markets,’ he said. ‘Because of where they are at the moment, they have much more room for innovation. For us, as investors, on the equity side we don’t invest in countries; we invest in securities, we invest in businesses. There are opportunities to pick the companies which are the most innovative in each country. There are risks; it’s a risk asset, no doubt about that, but because it’s a risk asset, there are benefits.’

 

Key Risks

Transactions in securities denominated in foreign currencies are subject to fluctuations in exchange rates which may affect the value of an investment. Returns can be more volatile than other, more developed, markets due to changes in market, political and economic conditions. Debt securities could suffer an adverse change in financial condition due to ratings downgrade or default which may affect the value of an investment.