Investing in emerging markets

Neil Hodge

While stocks in the US and Europe may be regaining some of the ground lost since the scale of the credit crisis became evident, such resurgent confidence pales in comparison to the attention that investors are now giving emerging and frontier markets

Fund managers feel that many developing countries have shaken off their legacy of debt and that since they now have current account surpluses, they are therefore deemed to be of investment-grade quality. Corporate governance is also improving and many companies are adding shareholder value by offering steady dividend payouts. More importantly, proponents of emerging market investing claim stocks are under-researched, under invested and, therefore, full of untapped potential. Just look at the figures in one emerging market – the Gulf States. The value of rights issues by Gulf-based companies has jumped to a record US$15.76bn over the last year, a 242% increase on the previous year.

Growth rates for the regions also sit well. The International Monetary Fund (IMF) predicts an average 6.8% growth each year for the next five years for developing markets. While that may be some way short of the double-digit growth enjoyed to date, it still outstrips the 2.7% forecasted for developed markets. And the Investment Management Association (IMA) Global Emerging Markets sector, which consists of 33 funds primarily invested in Latin America, Emerging Europe, the Middle East, Africa and Asia, has demonstrated the capacity for developing markets to outperform. Over three years on a cumulative basis to 30 June the average return was 80.1%, according to Morningstar, the fund research firm. This compares with the Global Growth sector, which returned just 25.5%.

Real estate is a particular favourite with investors. According to Real Capital Analytics (RCA), a research and consulting firm, the volume of real estate deals in the industrialised world fell 54% in the first quarter of 2008 compared with a year ago. But at the same time, the number of transactions in emerging markets jumped 43% in the first quarter. And the big investors are jumping in. A Citigroup survey of 50 major pension funds in the US and Europe found that portfolio managers want to commit some US$370bn to real estate over the next three years, in spite of the slowdown in their domestic markets.

Big chunks of that money are beginning to flow into countries such as China, India, Russia and the emerging economies of eastern Europe. Charles Schwab's US$228m Global Real Estate Fund, made its first foray into emerging markets in March. Analysts at Morgan Stanley are so upbeat that they expect a secular boom in emerging market property over the next ten years. They think developing nations will spend a massive US$22,000bn on core infrastructure projects during the period. Half of that, about US$11,000bn, will go towards construction. Although China is the emerging real estate giant, it is hardly alone. India saw property sales volume jump 210% in the first quarter over the first three months of last year, making it the world's fastest growing real estate market.

Frontier markets are also looking particularly attractive. These are popular with investors because they are largely uncorrelated with global markets, with other emerging markets, and with each other, which means that they are less likely to suffer from economic wobbles when other countries’ stock markets take a tumble. EPFR Global, a Boston-based company that tracks international fund flows, says that so far this year, inflows into the Middle East and North Africa have totalled US1.5bn, while China and India - though still regarded as attractive - have seen investors withdraw US$5bn from funds. The turnaround is due to economic reforms, a better banking climate and a growing credit sector.

In the past, Africa has attracted more retail than institutional investors as the latter have shied away from some of the continent’s small and illiquid stock markets. But now that the credit crunch has dented confidence in the world’s best-regarded exchanges, attitudes to frontier markets are beginning to change. Swiss banking group Julius Baer, which rolled out its Northern Africa Fund last September and recently launched it in the UK, has seen the fund grow from just US$15m at the beginning of the year to US$170m, with investment largely coming from the institutional side.

So maybe the credit crunch is not the global problem that it is always presented as. Perhaps it is only a problem for those countries that created the crisis in the first place – the US and Europe, clearing the way for nascent markets to show what they are about. And perhaps that is deservedly so.