Emerging market stocks have been on a rampage. The MSCI Emerging Markets index has climbed an impressive 49 per cent since the end of 2016, marking the end of a two-year bad spell.
But this growth doesn’t necessarily stem from the rise of the middle classes as many would expect, nor does it come from the deluge of exports being sold by these developing nations.
This is a far cry from 2011, when the biggest stocks were state-owned enterprises. These companies rarely work in the interest of minority shareholders, and will often leave investors disappointed as a result.
The prevalence of privately-owned tech companies with healthy profits makes this current collection of EM businesses look far more investable.
Meanwhile, the global recovery and dollar weakness also support the prospects of emerging markets, says Brewin Dolphin’s head of research, Ben Gutteridge.
“Beyond this, the vibrant technology sector will disrupt the EM asset class, which could represent a great opportunity for investors, akin to what we are seeing in the US tech stocks,” he adds.
While it sounds like a no-brainer to buy into these successful stocks using cheaper passive investment vehicles, there is a caveat.
Experts often warn of the inefficiencies in these emerging economies – that is, share prices don’t always accurately reflect the value of companies because there is a lack of information.
Actively managed funds typically tend to outperform in less developed regions of the world, whereas more mature countries like the US are often more supportive of passives.
But the question now is whether this conventional theory is turning on its head. “There is no doubt that the internet of things is going to be more important in the next 10 years than the last 10 because of urbanisation,” says investment veteran Gary Potter, who co-runs the multi-manager fund range at BMO.
While Potter agrees that EM indices have been powered by some amazing performances, he warns that if you pick away at the index, you will see outperformance from a small handful of stocks.
Investors therefore need to consider whether buying the hundreds of companies in the index is the best port of call.
“You’ve also got to bear in mind that the index is a rear-view mirror; if you buy the EM tracker today, you’re buying into something that already reflects some quite significant gains in some of those stocks.”
While it’s inevitable that the tech sector is going to grow over time, the only thing that determines whether you can profit from an asset is the price you pay for it.
Potter points out that some fund managers are reducing the “frothy” tech stocks because the price-to-earnings ratio of these companies is now astronomical.
It’s therefore important to look at the bigger picture, and not just be blinded by sexy tech stocks in a cheap investment wrapper.
In fact, the difference between the cost of EM passives compared to active fund isn’t all that different, making it even more important to take heed of what you’re getting for your money.
Darius McDermott from FundCalibre says passive EMs are not as cheap as you would expect. For example, the iShares Emerging Market ETF has an annual charge of 0.69 per cent, while fees for a US index tracker can be as low as 0.05 per cent. He also points out that index tracking funds in the emerging market space are few and far between, meaning you need to buy an ETF for more choice.
Another point to bear in mind is that Asia, and China in particular, makes up a huge part of the index, says McDermott. This means you need to have a positive stance on Chinese stocks in order to buy a passive.
While there are pros and cons to buying active and passive funds in any region, there is still a strong case to be made for hiring a fund manager to scope out the less researched companies that could be the next big stocks, and indeed the tech giants, of the future. This is even more the case in these more opaque markets like China.
McDermott adds: “An active manager can also do the due diligence and detailed work into corporate governance, so you can try to avoid the bad eggs.”
He recommends the RWC Global Emerging Markets fund, which has scooped up a return of 121.7 per cent after charges since its launch in January 2016, compared with a 84.5 per cent return from the MSCI Emerging Market index. Emerging market funds from Hermes Investment Management and Jupiter are also ones to watch.
The passive picture might look attractive in emerging markets, but it’s not a binary argument to track the index just because it’s the cheaper option.