Nobody likes missing a bull market, even if it's happening half a world away.
With stocks rising from Sao Paulo (IBOV) to Moscow to Istanbul, asset managers have piled almost $11 billion into developing-nation exchange-traded funds listed in the U.S. this quarter, the most since 2012, according to data compiled by Bloomberg. That's sent the premium of the biggest — Vanguard Group Inc.'s FTSE Emerging Markets ETF — to an average 0.2 percentage-point over its underlying assets, the widest gap in two years.
(Don't miss: Emerging-markets rebound hasn't convinced everyone)
Investors are returning to developing-nation ETFs after pulling $31 billion from them in the year through March on concern that the end of easy-money policies from central banks and flare-ups of violence from Thailand to Ukraine would destabilize markets. Stocks in emerging economies are outperforming developed for the first time in six quarters, climbing 5.2%, while all but three of 296 emerging-market sovereign dollar bonds tracked by Bloomberg gained in the first half, the broadest rally in at least three years, the data show.
(See where BlackRock star manager Dennis Stattman sees equity investing opportunities outside the U.S.)
“Markets have adjusted to the idea of policy normalization in the developed world,” Neil Shearing, chief emerging-markets economist at Capital Economics Ltd., said. “Concerns about emerging markets have eased a bit too. The Russia-Ukraine crisis hasn't really sparked the effects that some people had feared it might, and political risk in places like Turkey and Thailand have remained isolated.”
In Brazil, the Ibovespa Index entered a bull market in May, rising 20% from its March low, on speculation President Dilma Rousseff or a new administration will have to alter policies to bolster growth. Russia's Micex followed this month as President Vladimir Putin took steps to ease the conflict in Ukraine.
Turkish Prime Minister Recep Tayyip Erdogan fueled a 28% rally in the Borsa Istanbul 100 Index from its March low as he fended off corruption allegations to lead his party to victory in local elections. Thailand's benchmark SET Index jumped 21% from this year's low on bets the new military government will fast-track measures to revive the economy after tensions between former Prime Minister Yingluck Shinawatra's party and opposition politicians triggered a coup in May.
“Many of the best performing markets this year have been those where people see political change,” Nick Paulson-Ellis, co-head of global emerging markets at Espirito Santo Investment Bank in London, said.
Even after the rallies, valuations are near the lowest relative to developed countries since 2006. The MSCI Emerging Markets Index trades at 11 times estimated earnings for the next 12 months, compared with 15.1 for the MSCI World Index. The discount is close to the widest in at least seven years.
“Investors are willing to pay up to get into the ETFs, and don't have concerns they're paying slightly above the value of the holdings to do it,” Todd Rosenbluth, director of mutual-fund and ETF research at S&P Capital IQ, said. “We've seen signs of the global economy improving, economic prospects in China have picked up, and valuations in emerging markets became more compelling. We've also seen the Federal Reserve appear to stay accommodative with its policy.”
China's official Purchasing Managers' Index for manufacturing will probably be 51.1 for June, the highest since November, according to the median estimate in a Bloomberg survey of economists before data due July 1, signaling growth in the world's second-largest economy is gaining momentum.
Vanguard's $46.4 billion fund, the fourth-largest ETF (EMB) in the world, has attracted $1.3 billion of new money since the end of March, while BlackRock Inc.'s $39.7 billion iShares MSCI Emerging Markets ETF (EEM) has pulled in $5.9 billion, data compiled by Bloomberg show.
The inflows haven't been limited to equities. BlackRock's iShares J.P. Morgan USD Emerging Markets Bond ETF and Invesco Ltd.'s PowerShares Emerging Markets Sovereign Debt Portfolio, the two largest fixed-income ETFs focused on developing countries, attracted a total $1.3 billion in the quarter.
Developing-nation government bonds denominated in dollars climbed an average 8.5% this year. All but three securities included in the Bloomberg USD Emerging Market Sovereign Bond Index (BEMS) have posted gains.
The broad-based rally in emerging-market securities investors enjoyed in the first half won't last, according to Drew Nordlicht, a managing director at HighTower Advisors. Money managers will need to be more discriminating in the second half as the Federal Reserve continues to scale back monthly asset purchases that have helped developing nations lure foreign capital and cover up structural shortcomings.
“We're beginning to see a significant bifurcation in the performance of emerging markets,” Mr. Nordlicht said. He recommends buying shares of companies from Indonesia, Taiwan and Vietnam. “We're looking to avoid geopolitical circumstances that could derail our exposure, or circumstances where Fed tapering could cause monetary drains of capital.”
Elections in the coming months from Indonesia to Brazil and the ability of leaders from India to Egypt to fulfill pre-election promises will help determine which emerging markets continue to outperform, according to Espirito Santo's Paulson-Ellis.
Countries “that are able to implement reforms — those economies will continue to do well,” Mr. Paulson-Ellis said. “Emerging economies that fail to reform and implement the changes they need in their economies to remove structural bottlenecks will suffer.”