Investors continue to question the outlook for emerging market equities amidst growing concerns about political risk and economic growth. But there are reasons to be optimistic about a rebound, and research suggests that an active approach can be especially effective.
During the first quarter of 2015, the MSCI Emerging Markets Index rose by 11.6% in Canadian dollar terms. For the five years previous, however, through 2014, emerging market equities advanced by just 22%—half the cumulative gains of Canadian stocks, and well below other major developed markets.
Several factors could support a recovery this year. For example, weaknesses in key emerging currencies—including the Brazilian real, South African rand and Turkish lira—make many emerging companies look more competitive. China, India and other major developing countries are net importers of petroleum and other liquid fuels, so they will benefit from cheaper oil. And global liquidity from the European Central Bank and Bank of Japan could help to mitigate the impact of a potential Fed rate hike on emerging market stocks.
In this environment, investors who identify companies with specific advantages are likely to be rewarded. Examples include IT firms in India, textile manufacturers in China and Taiwan, and Mexican food groups that export to the U.S., all of which should benefit from favourable currency conditions.
Benchmark Troubles
However, even in a broad earnings recovery, the days of annual double-digit growth for emerging stock markets are unlikely to return. As a result, buying the benchmark isn’t the right way to go. In this context, active managers have a distinct advantage because emerging markets are more prone than developed markets to mispricing, and because information gets disseminated slowly. Research and discipline can be very effective for stock pickers, and there is fertile ground to find potential outperformers.
In order to capture the potential in emerging markets today, investors should keep four principles in mind. First, forget about the benchmark and rely on an active approach. Second, look for smaller and mid-sized stocks that are below the radar screen and capable of delivering strong returns. Third, manage risk proactively, because volatility is higher in emerging markets for both single stocks and entire markets.
Finally, use the Sharpe ratio, not tracking error, as a guide. This is because delivering stable risk-adjusted returns over time is the key to getting more punch from volatile emerging market equities.
Sammy Suzuki is Portfolio Manager of Emerging Markets, Strategic Core Equities, AB Global