Coping with the ups and downs of emerging markets can be difficult for investors, however, the case to include this asset class in every portfolio is gaining strength day by day.
While they are known for their risk and volatility and have been hit hard in the short term, equities in developing countries, including China, Russia, Egypt and Poland, have posted impressive returns over a long period.
The MSCI Emerging Markets Index surged 13.57 per cent each year in the five years to 31 July 2009, according to data from MSCI Barra.
The MSCI World ex-Australia Index and S&P/ASX 200 Accumulation Index in contrast added an annualised 0.99 per cent and 8.34 per cent respectively in the same period.
Many emerging countries are tipped to come out of the economic crisis with a vengeance and grow rapidly as their respective governments continue pushing reforms to boost people's living standards to those of advanced economies.
"If you look at China and India now, it's amazing when you consider we're in a global slowdown, but yet China is growing at 8 per cent and India 6 per cent. That tells you something about the growth prospects in these countries," Templeton Asset Management executive chairman Mark Mobius told IFA.
Although many observers have commented that the MSCI Emerging Markets Index's surge from its November 2008 low has been overdone or is a dead cat bounce, Mobius says developing countries equities are in a bull market.
"We're up about 70 per cent from the absolute low. Now of course you're starting from a very low base so it's easy to get very impressive percentages," he says.
"But there's no question in my mind that we are in a bull market. That doesn't mean, however, that we're not going to have corrections along the way. I was misquoted recently as saying that the market will go down by 30 per cent. What I actually said was it could go down by 20 per cent and maybe even 30 because these corrections are not surprising in this kind of environment where you have so many derivatives out there."
Another issue Mobius says is on many investors' minds is whether emerging markets are becoming too expensive. He says on a 10-year horizon, the price/earnings ratios of emerging markets reached a high point of 18 times in January 2000 and the current average is 12 times.
"In the case of book value, the high point was in October of 2007 when the average for emerging market stocks was about three times book; now it's two times book," he says.
Depending on their age, investors should be overweight in emerging markets, he says.
"Well it depends on the age group. I mean if I was a young person I would probably put 50 per cent of my equity portion in emerging markets," he says.
"As you get older you tend to be more cautious; you want to be closer to home. If you're in Australia and you want to have more in Australia, you may want to reduce the emerging markets component to maybe 30 or 20 per cent, but I definitely think you should be overweight in emerging markets."
New York University Stern School of Business professor Nouriel Roubini says on a medium-term horizon, he would invest in emerging markets as their potential gross domestic product (GDP) growth rate is 6-7 per cent, versus 2-3 per cent for advanced economies.
"I think that as long as emerging markets continue to do the kind of reforms they are doing, then they will be growing faster and returns are going to be higher than in advanced economies," Roubini told a CFA Society of Sydney luncheon in August.
But experts continue to debate the best way to access the asset class, including investing in country-specific, regional or broad emerging markets funds. A good starting point is examining how the developing economies - including the big four BRIC (Brazil, Russia, India and China) countries - and specific regions have fared during the global financial crisis and their future growth outlook.
China's remarkable resilience
Investors in Chinese stocks have endured one of the wildest rollercoaster rides of any market.
One of the country's most widely-watched stock market gauges, the CSI 300 Index, jumped from around 900 points at the start of 2006 to a peak of 5891 points in late 2007.
The index then collapsed nearly 73 per cent to a low of 1606 points by 4 November 2008, before staging a massive rally to close around 3344 points on 14 August.
"The main factor that initially hit the mainland stock market was that western companies had to sell their investments to recapitalise their own balance sheets and because of the fact that Chinese investments made the most money, they had to pull those out quicker and faster," Premium China Funds Management head of distribution and operations Jonathan Wu says.
"As western investors did that, Chinese investors also jumped ship and that's why the markets tanked much more than what the US and European markets did at the trough."
The Chinese market has staged a comeback for a number of reasons, including the fact the government's $693 billion stimulus package helped stabilise the economy and because investors are investing in the country's companies in a different way, he says.
"Instead of buying what the latest or hottest stock that their neighbour is buying, [Chinese investors] are thinking of the fundamental value of the company," he says.
China's GDP advanced at a 7.9 per cent annual rate in the second quarter of 2009, from a 6.1 per cent yearly rate in the previous quarter, according to the country's National Bureau of Statistics.
However, commentators argue that despite the robust figures, economic growth has been far slower than the double-digit figures achieved during the global boom and the country has been saddled with problems including slowing retail sales, deflation and rising joblessness, which may fuel social instability.
About 10 million people have lost their jobs as exports for Chinese goods plunged 23 per cent in the year to July, Wu says.
Yet, the risk of social instability - one of the key dangers of investing in emerging markets - is minimal as the government's stimulus funds support training packages for people who have lost their jobs, he says.
From a consumer demand perspective, although retail sales did cool from 25 per cent annual growth, figures show that people are still shopping. Retail sales have dropped back to around 15 per cent year-on-year growth as at the end of June, but the point is it still grew," Wu says.
Still, consumer savings make up 80 per cent of China's GDP, he says, signalling the government has a monumental task in pushing ahead with reforms so people spend and ensure the country's long-term economic prosperity.
"They need to find a way to unlock those savings and they are getting there by targeting three separate isolated issues: building a healthcare system similar to our Medicare, providing a better pension system and better education," he says.
China has introduced a $170 billion program to establish a similar system to Medicare. In August, the State Council said it was enacting a three-year action plan that would lay the solid foundation for equitable and universal access to essential healthcare for all of China by 2020.
China's government is also boosting the amount it spends on social welfare by 20 per cent each year and has developed a system similar to Australia's superannuation guarantee (SG). "Australia's is 9 per cent; China's is 10 per cent, but it's only for people living in urban areas. There is no such thing as super in the farmland or the rural areas," Wu says.
China has also developed policies to ensure all children in the country are granted eight years of free education.
"Now as long as the government works towards addressing these three major issues, they will be able to unlock the vast pool of savings because people will say 'well, the government is providing me with healthcare, education and a pension and I'm saving for my retirement already through their version of an SG'," Wu says.
But the highlight of all reforms China is pushing through is a land reform package that would give Chinese rural farmers the right to sell, lease or mortgage their land, he says.
"This is significant, as previously farmers weren't allowed to own land and suddenly they are sitting on a pile of cash," he says.
Around $356 billion in wealth would be created from this program, which could benefit 400 million people living in rural areas and spur long-term domestic consumption.
Wu argues given China's growth potential, advisers should allocate a substantial amount of clients' money towards China. "I challenge you to put, whether it be a conservative client or a growth client, 5 per cent of your client's portfolio into Chinese stocks and 5 per cent into Chinese property," he says.
Global sentiment hurts India
Like China, India has been hurt by the global financial crisis, particularly due to a dismal performance in the manufacturing sector.
GDP in the world's most populous democracy increased by 6.7 per cent in 2008/09, compared to 9 per cent in the previous corresponding period, according to India's Central Statistical Organisation.
The Bombay/Mumbai Stock Exchange Sensitive Index (BSE SENSEX) slumped from its peak of 21,206 on 7 January 2008 to a low of nearly 8000 points by 6 March 2009.
But listed investment company India Equities Fund chief executive John Pereira says the dramatic fall in the stock market has more to do with global sentiment than any domestic concerns. "India's own domestic market has remained very strong and the proof in the pudding for that is the World Bank's GDP forecast of 8 per cent growth in India during 2010," Pereira says.
That GDP growth is propelled entirely by domestic demand for better goods and services, unlike China's, whose growth is dependent on exports and amplified by the performance of advanced economies.
"There is a 250 million-plus group of people with a median age of 25 aspiring to join the ranks of the middle class and demanding better good and services," Pereira says.
Like many emerging markets, the BSE SENSEX has made a stellar recovery and closed at 15,160 points on 10 August 2009.
The rally has been fuelled by factors including the return of foreign capital and re-election of the Indian Prime Minister Manmohan Singh-led Congress Party.
The BSE SENSEX skyrocketed a record 17 per cent on 18 May when he was returned as leader. The index finished 23 per cent higher for the month.
"It's the single most watershed event that's happened in India recently," Pereira says. "What people have to understand is that in the last five years, Singh has guided the country in what I call the opening of the economic corridors of India."
Still, market observers have signalled caution on India's outlook as the government plans to borrow a record amount of money to fund stimulus packages designed to sustain growth.
India's government in July said it would issue $112 billion for the 2009/10 fiscal year and carry a fiscal deficit of 6.8 per cent, the biggest in 16 years.
"The issue about the government deficit is really applicable globally," Pereira says.
"India is a country that has been slowly moving up the scale in terms of foreign reserves and it has never, ever defaulted on any of its obligations."
"The government is continuously improving and expanding its tax net. It is diligently running both fiscal and monetary policies, which will drive better greater tax collection.
"It's driving a policy of foreign direct investment, it's looking for joint venture partners, private-public ventures and if it can do it successfully then I don't think India will have any problem from a financial status viewpoint."
India is in a prime position to enjoy a healthy GDP not just in 2010 but possibly and probably for the next five years plus, Pereira says.
He argues retail and institutional investors should allocate 2-3 per cent of their total portfolio to China and India - and that allocation should be separate to other emerging markets.
"You cannot ignore two countries with nearly 3 billion people and that have some of the largest companies on earth," he says.
Americas and eastern Europe mired in slump
Countries in Latin America have been affected in different ways throughout the financial crisis.
"We've seen economies dependent on the US like Mexico struggle and Mexico unfortunately has also struggled with the outbreak of swine flu," Aberdeen Asset Management senior investment specialist Stuart James, who represents the $118 million Aberdeen Emerging Opportunities Fund, says.
"So we've seen Mexico's GDP collapse dramatically this year. It's down about 20 per cent for the year to March, so it's one of the worst-hit economies in the world.
"One of the other key developments in Latin America has been the rise of nationalistic governments, including in Venezuela and Bolivia."
However, James says he is optimistic on Brazil, South America's largest economy.
Although its exports have suffered, Brazil has a strong consumer demand story due to a thriving middle class and a government that has the means to implement strong monetary and fiscal measures to stoke demand.
"Brazil has actually been cutting interest rates in this environment, which is almost unheard of. Normally they would be hiking rates to protect the real," he says. "The other good news for Brazil is it has a much better trade balance sheet or terms of trade. So in that sense it's not required to protect the currency to the same extent and therefore has been able to cut interest rates, which have stoked current demand."
Eastern Europe, which for years binged on cheap credit, has arguably become the worst-hit region amid the global financial crisis.
The region, which includes countries from Belarus to Ukraine, had $1.78 trillion in borrowings as of 2008, according to statistics published in September by the Bank for International Settlements.
Eastern European borrowing tripled from 2005 to 2008 alone.
The loans - which were used to modernise local industries and purchase consumer durables and real estate - helped propel years of rapid growth. But when the global financial crisis hit, everything that could go wrong did go wrong.
Banks stopped lending, credit markets froze, foreign capital evaporated, stocks collapsed, demand for exports plunged and housing prices fell - all leading to unprecedented economic fallout and misery throughout the region.
In Estonia and Lithuania, GDP shrank by 16.6 per cent and 22.4 per cent respectively in the 12 months to June, data from their statistics offices show.
Others, including Ukraine and Hungary, turned to the International Monetary Fund (IMF) for loans to avert default.
"In some ways I think eastern Europe is currently displaying the characteristics Asia did in 1996-98. So now eastern Europe almost falls into the same basket as developed markets," James says.
He says there is no doubt the economic model eastern Europe is following is structurally flawed and cannot be sustained.
"It's going to take a massive restructuring of the economy and a significant paying down of external debt and that will take some relatively nasty medicine to bring those balance sheets back in line," he says.
Although Russia does not have the same external debt levels as the rest of eastern Europe, the country suffered immensely due to its dependence on oil and metals exports, which collapsed both in volume and price in 2008.
The region's largest economy shrank by a record 10.9 per cent annual rate to June, according to Russia's Federal State Statistics Service.
In terms of investments, Aberdeen does not have a positive view on eastern Europe with respect to emerging market regions.
"It's probably the area we're least excited about . we prefer Asia because it has a very strong consumer demand story," James says.
"Latin America does have strong demand but also has the commodities story.
"So eastern Europe is lacking one of those two key drivers and is likely to be a laggard in terms of investment performance. But having said that there are some companies that are in excellent shape, have a good end market and will do very well." He recommends investors hold about 15-20 per cent of the international equities component of their portfolio in emerging markets.
"If you look at the MSCI All Country World Index, emerging markets represents about 10 per cent of that index and within our own international fund we have 15-20 per cent exposure to the asset class. So it's what we do ourselves," he says.
However, he warns that risks with the asset class do exist.
"As much as we're bullish on emerging markets, obviously these are still emerging markets. Some of them can be susceptible to political problems and they are operating with a global economy," he says.
"So while the headwinds remain in advanced economies, some developing countries are going to continue to suffer on the exports side.
"So it's really about finding the right companies at the end of the day, rather than investing in emerging markets per se. They're not all equal and you do need to understand all the nuances."
IMF projects faster growth
As the experts put it, investing in emerging markets, despite their risks, is a strategy that makes sense as these regions have the potential for the best long-term economic growth, hence better returns.
The IMF in its latest world economic outlook projects emerging and developing economies to expand 1.5 per cent in 2009 and 4.7 per cent in 2010.
Developing Asia is projected to be the best performer, with 5.5 per cent expansion in 2009 and 7 per cent in 2010.
In contrast, output in advanced economies, including the US, Germany and Italy, is projected to shrink 3.8 per cent in 2009 and grow 0.6 per cent in 2010.
Financial planners in Australia have access to a range of actively-managed funds from numerous active managers offering exposure to developing economies.
The introduction of exchange-traded funds has also made it easy to gain country/regional or broad emerging markets exposure via the Australian Securities Exchange, a strategy being adopted by several advisers focused on high net worth individuals and self-managed superannuation funds.
