ETF Investors Pounce on Cheap Emerging Markets

After valuations contracted through 2018, investors in exchange traded funds have begun to build their emerging market equity exposure up

David Brenchley 21 February, 2019 | 8:41AM

Shanghai, China, emerging markets, passive funds, ETF

ETF investors rushed to buy in the dip in emerging market assets after a severe correction in markets at the end of 2018, data from Morningstar Direct shows.

Investors in Europe-domiciled exchange traded funds pumped €4.5 billion into emerging market equity mandates through December and January – the two strongest months on record for inflows into the asset class.

Some plain vanilla ETFs from iShares (EIMI), Amundi (AUEG) and UBS (UB32) were among the best sellers. A minimum volatility twist on iShares’ aforementioned offering (EMMV) was the second most-popular, as was iShares EM Dividend ETF (SEDY), suggesting more defensive positioning is favoured.

A plethora of headwinds – not least a strong US dollar, rising US interest rates and trade uncertainty – rocked emerging markets last year. The MSCI EM Index declined almost 15% through the 12 months, compared to an 8.7% loss in the MSCI World Index, which tracks developed market stocks.

That left emerging market stocks looking cheap, both relative to their own history but also to their developed market peers. As a result, investors swooped, with €2.4 million of net cash flowing into emerging market ETFs in December alone.

A further €2.1 billion came in last month as the asset class had a relief rally as the US Federal Reserve became more dovish and worries of an all-out trade war between the US and China receded. The MSCI EM Index is up 7.5% in the year to 18 January.

However, developed market stocks continue to outperform. The MSCI World Index is up over 10% during the same time. Therefore, it could be argued emerging market equities are still undervalued.

Emerging Market Bulls

Indeed, Nick Watson, a portfolio manager on Janus Henderson’s UK-based multi-asset team, argues exactly that. “In this environment of a more dovish Fed and a bit more Chinese stimulus that’s not necessarily a bad time for emerging markets,” he says.

“We added in November, which was probably a little bit early, but you have a valuation argument in emerging markets because, quite frankly, no-one likes them. That to us is quite an interesting opportunity.”

River & Mercantile’s Al Bryant adds a few more factors into the mix that could be long-term positives for the region: beaten down currencies, attractive dividend yields and improving profitability.

“A large cross-section of emerging market companies have improved balance sheets and have been showing an improvement in profit margins,” continues Bryant. “Dividend yields also now average above 3% for emerging market stocks, which has been a decent historical signal for subsequent gains.”

Another who is positive on emerging markets in 2019 is Saker Nusseibeh, chief executive officer at Hermes Investment Management. He thinks there are more reasons to be optimistic about emerging economies than developed ones.

Nusseibeh notes the plethora of uncertainties facing Western economies in the near term – including US politics, heightened geo-political tension, an ongoing European slowdown and Brexit – could hold them back for now.

“Given this level of uncertainty, I am more confident in the possibility of finding long-term value in markets that are still emerging than the signs that I see in more established ones,” he explains. “In the short term, at least, I think there is more upside in Eastern emerging markets than their developed neighbours to the West.”

Nusseibeh does caveat his view that he’s “always aware that one correction does not preclude another”. Bryant, meanwhile, accepts there the possibility that emerging market stocks are cheap for a reason. And others put more cautious views on the table.

Research house Capital Economics notes that while valuations have fallen, they are not exceptionally low. In fact, at a price/forward earnings ratio of 10.5 times, the MSCI EM Index is actually trading in line with its post-financial crisis average.

Economists at the firm believe that the near-term outlook for emerging market assets is “bleak”. Ian Beattie, co-chief investment officer at investment manager NS Partners, isn’t quite as pessimistic. In fact, he is constructive on the longer-term outlook.

But he told clients advisers at a recent investment summit in London run by Nedgroup Investments, for whom NS Partners runs an emerging market mandate, he’s “not really banging the table just yet”.

“Yes, they look cheap relative to the rest of the world, but they looked quite cheap this time last year and we weren’t that optimistic then,” Beattie said explained. “But we do see the ingredients in place for maybe sometime later this year we might have everything aligned and it could be a very, very attractive opportunity.”

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

David Brenchley

David Brenchley  is a Reporter for Morningstar.co.uk

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