When investing in emerging-markets economies, stock picking beats indexed exposure

Investing in emerging-markets economies is less about why than about how and where.

Publicly traded companies in the emerging markets with a market capitalization of at least $300 million are represented by more than 6,000 stocks. That compares to 5,000 stocks in developed markets outside the U.S., and 3,000 domestic stocks above the same market cap. In terms of the total economic footprint, the 22 countries defined as emerging represent between 35% and 50% of the world’s economic output.

With that in mind, Marcio Silveira, founder of Pavlov Financial Planning, has no trouble allocating 30% or more of his clients’ portfolios to emerging markets.

“There are lots of economic reasons to expect consistent long-term outperformance from the emerging markets,” he said. “And within the category, there is already so much embedded diversification, because the drivers of economies like Turkey and Mexico are very different from the drivers of economies like China and Russia.”

A 30% allocation to emerging-markets stocks is probably beyond where most financial advisers are currently positioning their clients, especially considering the steady six-year rally in U.S. equities. But whatever the weighting, the case for investing in emerging economies is often an easy one to make.

FASTER GROWTH

“If you have a 10-, 15-, or 20-year horizon, it’s difficult to say developed will grow faster than emerging markets,” said Krishna Memani, chief investment offer at OppenheimerFunds.

Like a lot of emerging-markets specialists, Mr. Memani offers a nod toward broad market exposure through some of the popular indexing strategies, but says for more reliable exposure, stock picking is better. Overall, he said investors with time to do the research can’t go wrong investing in economies associated with growth.

TYPICAL RISKS

Jonathan Brodsky, managing director at Advisory Research Inc., added that when investing in any emerging market, investors need to be aware of the typical risks, such as inflation, regulation, rule of law and politics. In essence, it is more than just a straightforward measurement of gross domestic product that gets factored in when defining and analyzing an emerging economy.

“If you have a 10-, 15-, or 20-year horizon, it’s difficult to say developed will grow faster than emerging markets.”— Krishna Memani,  chief investment offer at OppenheimerFunds.

“An emerging market is a classification with a variety of different meanings,” Mr. Brodsky said. “Some emerging markets are classified as emerging because of capital controls that make it more difficult for investors to trade there, such as places like Taiwan, South Korea, India and Brazil. Any visitor to Taiwan and South Korea would find it hard to distinguish between those markets and a developed market.”

While Mr. Silveira can be commended for taking his clients well beyond the bread-and-butter heavy allocation to domestic stocks that most U.S. investors have, he might be missing some of the emerging-markets advantage by sticking with broad indexed exposure.

Mr. Memani emphasized that the best way to take advantage of what happens in emerging economies is to focus on specific companies.

“With international in general, and the emerging markets in particular, it is about the companies, not the countries,” he said. “I don’t want to invest in China, I want to invest in the fastest-growing companies in China.”

In other words, if you really want to tap into the growth potential of the world’s emerging economies, you might need to step outside your comfort zone a bit and embrace the idea that growth often comes with volatility.

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MORE VOLATILE

“The emerging markets are going to be more volatile than the average developed-market fund,” said Todd Rosenbluth, director of mutual fund and ETF research at S&P Capital IQ. “The risk profile will be much greater, but we would encourage investors to embrace that and be prepared. But still look for funds that are less volatile than their peers.”

For broad market exposure, Mr. Rosenbluth highlighted $33 billion iShares MSCI Emerging Markets ETF (EEM), which has an expense ratio of 68 basis points, and is up 9.1% this year through May 13. The $50 billion Vanguard FTSE Emerging Markets ETF (VWO), which does not include South Korea, costs just 15 basis points, and is up 10% this year.

Mr. Rosenbluth also noted, on the passive side, the $7.8 billion iShares Core MSCI Emerging Markets ETF (IEMG), which includes more small companies, costs 18 basis points, and is up 2.8% this year.

Even as he recognized the stock-picking advantages of actively managed funds in emerging economies, Mr. Rosenbluth flagged the significant hurdle imposed by the higher fees those funds carry.

The $8.9 billion T. Rowe Price Emerging Markets Stock Fund (PRMSX), for example, has an expense ratio of 1.2%, and is up 8.6% this year, compared with a category average of 6.2%. The $24.4 billion American Funds New World Fund (NEWFX) has an expense ratio of 1%, and is up 5.2% this year. And the $11 billion Virtus Emerging Markets Opportunities Fund (HEMZX), which has an expense ratio that matches the category average of 1.6%, is up 2.7% this year.

“In theory, the good thing is the active manager is going to take a look at broad emerging markets and be able to try and spot which regions and companies that are best-positioned,” he said. “But when the average expense ratio for an active fund is 1.6%, the fund better be able to do well for that much money.”

David Semple, head of emerging market equity at Van Eck Global, said it is an oversimplification to think of emerging markets investing only in the context of large and popular index strategies.

“The trouble is, emerging markets in many people’s perception, is this amorphous block, but it is actually made up of several individual drivers,” he said. “There are parts of the emerging markets where we see great opportunities, but just looking at it as indexes is a very skewed representation.”

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