In Hot Emerging Markets, It Pays to be Cautious
Our fund screener can help you get emerging markets exposure with less heartburn.
Emerging markets stocks have flourished in recent years. And not surprisingly, the funds that invest in them have shined. Indeed, over the past one- and three-year periods, the Morningstar Emerging Markets Equity category has been one of the top performers among all of our European categories. Moreover, over the past five years, the average fund in the group is up a very impressive 29% annually. Such big gains are certainly enticing, but chasing performance is the wrong reason to invest in this group.
Interestingly, emerging markets performed well against developed markets in 2007 despite investors’ flight from riskier asset classes amid the global credit crunch. But don’t think emerging markets are a safe haven. You can lose a lot of money and fast: In 1998, for instance, the typical European Emerging Markets stock fund dropped 25%.
Of course, there’s certainly a good case for emerging markets investing. The asset class can be a good tool for diversification—last year shows that the group won’t always move in step with global markets. But given that gains can be wiped out in a hurry, we thought we'd take a look at several funds that have managed to limit their risks a bit more effectively than their rivals.
In keeping with that goal, we’ll show you how you can use our Morningstar Fund Screener to identify emerging markets funds with lower-than-average Morningstar risk relative to their peer group. (Like standard deviation, one of the most-common gauges of risk, Morningstar Risk also measures volatility, but it places added emphasis on the downside). Lower-risk funds may stand a better chance of showing resilience in an emerging markets downturn.
The Screen
Using the fund screener, we’ll first set the Morningstar category to Emerging Markets Equity. To help ensure we eliminate the riskier offerings, we’ll highlight the low and below average boxes on the Morningstar Risk bar, which is located under the tab labelled “Fund Performance and Risk”. Then, to keep costs in check, we’ll use the expense ratio bar, located under the next tab “Fund Fees and Purchase Details,” to limit our search to funds with a total expense ratio (TER) below two per cent and set the minimum initial purchase to £2000 to eliminate as many institutional share classes as possible.
The set of screens leaves us with a total of 6 funds: Danske Global Emerging Markets, First State Global Emerging Markets, First State Global Emerging Markets Leaders, Aberdeen Emerging Markets, Legg Mason Emerging Markets and Lincoln Emerging Markets Trust.
Sifting Through the Results
Our search for an emerging markets fund with lower risk relative to its peer group has been whittled down to six options using the fund screener. However, it shouldn’t be the be-all and end-all, of your search. Morningstar Risk is good at what it does, but it is a backwards looking, performance-based measure, and as such cannot capture portfolio risks that may not yet be reflected in past performance.
Take the Aberdeen, Lincoln and Danske funds as examples. These offerings can take sizable positions in individual sectors, making them vulnerable to big losses if things don’t go their way. While the average fund in the category invests about 23% of their portfolios in financials stocks, the Aberdeen and Danske funds have around 32% in the sector and the Lincoln fund has 29%. Moreover, it’s worth noting that not all of these funds have been tested by a tough environment. The Aberdeen fund’s history stretches back to only late 2003, so it has only been around in mostly good times. The First State emerging markets offerings have a big slice of their assets in Asia, but managers Angus Tulloch and Jonathan Asante are experienced investors in this asset class. They place a strong emphasis on valuation, which can keep them out of hot-performing sectors. The pair has remained on the sidelines when cyclical industries have been booming, particularly during the energy and industrial materials rally of late. That cautious stance can hold the funds back at times (they’ve lagged in recent years). But they’ve shown resilience in difficult markets. Global Emerging Markets (now closed to new investors), for instance, handily outpaced the competition in the early 2000s bear market. So while investors have foregone some performance in the short run, First State’s relatively conservative style has paid off in the long haul.
