Emerging markets consists of countries that are still in the process of building their core infrastructure and developing their industrial base. Regions included in the emerging market umbrella are Asia, Eastern Europe, Latin America, South Africa and the Middle East. Aside from Asia, the other emerging markets do take up a meaningful proportion of indices that represent emerging markets. The MSCI Emerging Market Index has 47% in Latin America, Emerging Europe and the other emerging markets including South Africa and Middle East.

Chart 1

Source: MSCI

The table below shows the weightage of the regions for the MSCI Emerging Market index and the emerging market funds, including First State GEM Leaders, Franklin Templeton F-Emerging Markets, Schroder Emerging Market Fund and Aberdeen Global Emerging Markets Fund.

Table 1: Comparison of Weights

Source: MSCI, Schroders, Franklin Templeton Investments, First State Investments

Emerging market equities have done well over the past 2 years. The MSCI Emerging Market Index rose 48.4% in 2003, 17.7% in 2004 and 15.7%in 2005 on a year-to-date basis (as at 16 August 2005 and in SGD terms). Chart 2 shows us that since March 2003 till August 2005, the index has doubled in value. In addition, if we compare the performance of this index to other developed markets, emerging markets (represented by the MSCI Emerging Market Index) have performed better. This index is all encompassing and includes Latin America, South Africa and Eastern Europe other than Asia ex-Japan.

Chart 2: Performance of MSCI Emerging Market Index

Source: MSCI

Table 2 shows that in 4 out of 5 years, the MSCI Emerging Market index rose more than the other indices, even the MSCI Asia ex-Japan index. For example in 2003 and 2004, the MSCI Emerging Market index returned 48.4% and 17.7% respectively, but the MSCI Asia ex-Japan index rose 39.7% and 10% respectively. On a year-to-date basis, the index was also the best performing index returning 15.7%. This actually meant that other than Asian equities, the rest of the emerging market equities have also been performing exceptionally well. The strong performance of the rest of the emerging European markets including Latin America and Eastern Europe boosted the performance of the overall emerging market index. In the next two weeks, we shall take a closer look at these two regional markets. For now, let us analyze the whole emerging market sector.

Table 2: Comparison of performance between MSCI EM & other Markets in SGD terms

Source: MSCI, Bloomberg

Why are emerging markets performing so well, especially in the past two years? Let us look at some of the drivers of market performance.

Drivers For Emerging Market Equities

The emerging market economies have come a long way from the days that they experienced political instability, poor economic growth and high levels of inflation. The first driver for the emerging market equities is the strong economic growth rate that they have been experiencing since 2003. Strong export sales and domestic spending largely drive economic growth. These two factors propelled economic growth and increased the attractiveness of investing in emerging market equities.

Chart 3

Source: IMF, World Economic Outlook April 2005

The second driver, we believe, is the attractiveness of the emerging market sector hinging from strong earnings growth and attractive valuations. When emerging market companies benefit from better revenues through a higher volume of exports and sales, they tend to report better earnings. Thus, investor sentiment has been generally positive as companies report strong earnings and expect a continued growth in those earnings. In a recent Dow Jones report dated 16 Aug 2005, fund managers continue to view emerging markets as the most favourable asset class for corporate profits. Valuations in emerging markets are also generally more attractive end in comparison to other developed markets including United States, Japan and Europe. For example, the valuations for Brazil (the largest market in Latin America) are 8.2X and 6.8X (Source: CLSA, MSCI & IBES) for 2005 and 2006 and the valuation for US is at 18.7X and 17X (Source: Fundsupermart) for the respective years.

The third driver that we shall touch on is the strong likelihood that population demographics would continue to drive domestic consumption. Table 3 shows a breakdown of the proportion of the different age groups in different countries. Emerging countries such as Brazil, Mexico and Turkey tend to have a younger population demographic. For example, the proportion of the population that is under 15 years of age takes up 30% of the total population. As these teenagers grow to become young adults, they will start to spend on bigger-ticket items such as travel, cars and homes. As the countries prosper economically, individuals become more affluent and spend more on daily necessities such as clothes, food and jewelry etc. If domestic spending continues to trend upwards, companies that are selling to the domestic crowd will benefit from stronger sales and better profits.

Table 3: High Proportion of Younger Population

Source: Bloomberg

These are just three of the main drivers that we believe is likely to result in stable and strong equity performance in the next five to ten years. Let us take a look at some of the funds that invests into emerging market equities.

Emerging Market Funds

As mentioned earlier, we currently have four funds that invest in emerging market equities. They are namely Aberdeen Global Emerging Market Fund, Schroder Emerging Market Fund, Franklin Templeton F-Emerging Market and First State GEM Leaders. We are only able to compare the returns of the last four funds, as the Aberdeen Global Emerging Market Fund is a newly launched fund. Although the performances of these emerging market funds were strong, these funds did not outperform the benchmark MSCI Emerging Market Index. Schroder Emerging Market Fund was the best performing fund in the 1-year period as at end July 2005.

Table 4: Offer-to-bid annualized return (%) in SGD as at end July 2005

Source: Fundsupermart, MSCI
The performance figures in the table above is calculated using offer-to-bid prices, with any income or dividends reinvested.

However, over other periods, the Franklin Templeton F-Emerging Market fund was the best performing fund. The main difference between these two funds is that Schroders tend to take a top-down approach in selecting equities whereas Franklin Templeton has taken up a bottom-up approach. Similar to Franklin Templeton, First State GEM Leaders also takes a bottom-up approach in stock selection. One distinct difference between these emerging market funds (illustrated in the table) would be – Franklin Templeton Emerging Market Fund invests a larger portion outside of Asia excluding Japan (which is about 47%). In comparison, the other two funds invest slightly less in regions other than Asia excluding Japan – about 39% to 40%.

The newly launched Aberdeen Global Emerging Market Fund (which is not included in the table) takes on a bottom-up stock picking strategy based on two stringent criteria: quality and price. There is also a difference in terms of regional allocation the fund invests 38% in Latin America and Emerging Europe equities as at June 2005. That means that this fund is more heavily weighted in these two regions in comparison to its peers. The investment style is consistent with the way they manage their Aberdeen family of funds. However, unlike the popularly held Aberdeen Pacific Equity fund, this fund is not a fund of funds, it directly invests into emerging market equities.

Conclusion

We think that these developing markets have a strong potential to perform well over the long term, say in the next 5-10 years. Wage levels tend to be lower in these markets and this attracts foreign companies to build their production bases in their country. As industrial production levels increase, there will be a positive spillover effect to export growth. As exports and industrial production improve, companies in these regions are likely to reap the benefits and report better earnings. We think investors can consider investing a portion of their portfolio in these funds for the longer term, say 5-10 years. The funds that we have mentioned invest in less well-known markets such as Latin America and Eastern Europe and present an opportunity for investors to get exposure to these markets. In the next two weeks, we are going to take a closer look into these two regions.

With these points in mind, we would also like to advise investors that, similar to Asia equities, emerging market equities in regions such as Latin America and Eastern Europe are more volatile in nature in comparison to global equities. Thus, it is important for investors to consider their ability to take risk before investing in these emerging market equity funds.