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Growth Potential.

Byline: John Keefe

Summary paragraph: Investors need to endure volatility with emerging markets

Art by Kyle SteckerOver thhistory, emerging market equities have presented an investment puzzle. Developing economies tend to grow faster than their established counterparts: The International Monetary Fund projects their aggregate gross domestic product (GDP) growth at 4.3% for 2015, versus 2.4% for the advanced economies. They follow an erratic path, however, and in the current investing climate are on the downswing. Weak prices in global commodities markets have hurt revenues, exposing structural weaknesses in some economies. Emerging market currencies have weakened, causing central banks to sell their U.S. dollar reserves to defend them. But the emerging world includes a lot of territory, and investment managers say that, in spite of tough conditions in some countries, there is no shortage of good stock ideas.

Whether they know it or not, most participants in defined contribution (DC) plans likely own emerging market equities, as those make their way into portfolios in several ways. One is as a sliver of the diversified equity holdings in target-date funds (TDFs); a second is by an allocation-typically as high as 25%-to emerging markets in international equity fund options.

Both of those options are widely offered within the defined contribution plan universe, says Vanguard Group in the firm's 2013 study "The Outlook for Emerging Market Stocks in a Lower-growth World." The third, free-standing emerging market equity funds, is relatively rare. Just 27% of participants in Vanguard plans were offered a separate emerging market equity option in their fund menus, and only 8% of those participants actually owned one.

Generally, plan consultants and advisers believe the investment choice in emerging markets is best left to professionals. Over long periods, the growth in emerging economies has delivered attractive returns: For the 10 years ended in March, the MSCI Emerging Markets Index earned 8.8% annually, on a gross dividend basis, versus 7.0% for the developed market MSCI World Index. To enjoy the gains, however, investors have had to endure considerable volatility. The accompanying chart plots the MSCI Emerging Markets Index against the MSCI World Index from the end of 1989.

Emerging market stocks suffered a few difficult years in the late 1990s, in response to a crisis in currencies that started in Asia and spread around the developing world. Otherwise, the investments had a terrific run, from the turn of the century until the 2008 financial crisis. Markets sold off sharply, though in roughly the same proportion as did the developed markets. For the past several years, though, emerging markets have handed in disappointing records. Peaking in early 2011, they have since followed a choppy path, with a loss of about 7% in total by the end of this year's first quarter, versus a cumulative gain for the developed markets of 45%.

The 2011 market top for emerging markets, and the subsequent sell-off, coincides with a peak in commodities prices.

The move in tandem with commodities has been a letdown to emerging market devotees. In the early years of emerging market investing, commodities exports were the prime mover of many economies. Mexico and Russia were highly dependent on oil and natural gas, for example, and Brazil was-and still is-a major producer of corn, soybeans, sugar and, of course, coffee. But as these economies rapidly grew, investment strategists made the case that an expansion in incomes would establish a widening middle class-and in turn promise greater domestic consumption-making the emerging markets self-sufficient and less reliant on commodities exports.

That evolution away from commodities has failed to come quickly enough, however. Agricultural and oil prices are off, due to excess production, and industrial metals markets have faded on slowing growth in demand from China.

However, some countries are not big commodities exporters and stand to benefit from lower prices, particularly for oil. These differential effects highlight the benefits available through active portfolio management. "The emerging markets are not homogeneous," observes Chuck Knudsen, an emerging markets portfolio specialist at T. Rowe Price Group, Baltimore. "In Indonesia, the market was up 24% last year, and Russia was down 49%. Looking at sectors, health care in emerging markets was the best performing, up 20%, and the worst performing-energy-was down 20%. That wide dispersion will likely continue, and that sort of market provides attractive opportunities for active managers."

"When you buy an emerging market index fund, 10 out of the top 20 companies are state-owned, and they are not run for shareholders," says Sammy Simnegar, portfolio manager of the $3 billion Fidelity Emerging Markets Fund, of Fidelity Investments in Boston. Index funds weight their positions according to companies' market capitalization, irrespective of the health of their fundamentals or quality of governance. "With active management, I can be overweight in companies that are exporting a lot to the U.S. and other countries where things are stronger," he explains. "Most of the opportunities I am finding are in the range of $1 billion to $10 billion in market cap and have their destiny in their own hands.

"Health care is a bright spot," he adds. "For hospital chains, there is medical tourism, such as in Thailand, where people travel from more expensive areas for treatment. In the Middle East, incomes are rising and governments have expanded mandatory health care, increasing demand." He also cites consumer discretionary stocks; lower oil prices put more money in people's pockets, although not in every developing country. "Consumption had been growing across the emerging markets for the last 10 years, but today you have to pick your spots."

"One place we see value today is in the Philippines," says T. Rowe Price's Knudsen. "The stocks don't necessarily look cheap, but with the growth trends that are in place, and the reforms the government is implementing, the companies can grow into those valuations."

At times, owning the emerging markets can make for a bumpy ride, but their long-term growth prospects and diversification potential make them a promising addition to global equity portfolios. According to Roger Aliaga-DAaz, senior economist on the global economics team at Vanguard Group, Valley Forge, Pennsylvania, "Emerging markets are a meaningful share of the global market cap, currently making up about 10% of the world stock market value, but they are close to 39% of global GDP and 86% of the global population."

Vanguard offers two options, one indexed and one actively managed. "You have to think that the emerging markets will become a larger part of global equity exposure," Aliaga-DAaz says.

-John Keefe
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Date:May 1, 2015
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