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An emerging market index fund for UK investors

Emerging markets are on everyone’s horizon

Being a cynical old soul, I raise an eyebrow at the launch of any financial product – even one as potentially useful to UK investors as an emerging markets index fund, such as the new one from Legal and General.

It’s not just my well-founded fear that where financial firms lead, exploitation often follows.

It’s also that hot-and-hyped sectors have a habit of delivering cold returns, as we saw with:

  • Japanese funds in the late 1980s
  • Technology funds in 2000
  • Commercial property funds in 2006
  • Government bond funds in 2010 [pending]

Will the emerging market hype end in tears? The stage is certainly being set.

We heart emerging markets

Everyone from hedge fund managers to the man on the Clapham omnibus knows that emerging markets are where the growth is.

Chinese GDP is expanding at over 9% a year. India is growing at 8.9%, and Brazil is close behind. More developed Asian countries from South Korea to Thailand are still growing, too, and even Russia is bouncing back.

These countries are as different from each other as they are from Britain, America, Western Europe and Japan, but they do share several traits:

  • Young demographics
  • A shift from agriculture to industry
  • Migration from the countryside to the cities
  • Improving infrastructure
  • Lots of natural resources
  • (Often) relatively little public or private debt
  • A taste for Western lifestyles

It doesn’t take a genius to see that a country growing at 8% with a lot more young people than pensioners and a big trade surplus has a lot more room to grow than Italy, Japan – or us for that matter.

Great story, great returns (so far…)

For the past few years, those booming economies have been coupled with great returns for investors.

Compare the performance of the FTSE All World Emerging Market Index with the UK’s FTSE All Share in successive 12-month periods to the end of September:

Index 2006 2007 2008 2009 2010
FTSE AW Emerging Index 16% 45% -22% 34% 23%
FTSE All Share 15% 12% -22% 11% 12%

Not only has the emerging index beaten UK companies in the good years – it didn’t do any worse in the dire year of 2008, either.

Here’s how your money would have grown over those five years:

Wow! (But remember, the past is no guarantee...)

Chasing economic growth: Risky

Does the strength of emerging economies mean you can just move all your money into them and start leafing through Saga’s retirement brochures?

Not quite. The phrase ‘past performance is no guide to future performance’ isn’t just a disclaimer that fund managers use to get themselves off the hook.

As I mentioned above, previously hot sectors have a habit of blowing up, although nobody can know exactly when and as we saw with the tech boom in the 1990s, they can run for years. Emerging markets have soared and crashed before!

Also, the growth in the index above shows how the price of companies has increased over the past few years.

It doesn’t mean those companies are necessarily performing brilliantly (although many of them are). It could – and does – partly mean that investors are prepared to pay more for them, not least because more investors around the world now want to own a piece of the emerging market action.

This ‘re-rating’ is subtle but important:

If investors were prepared to pay 10x earnings for a £100 million company making £10 million a year, and decide they’re prepared to pay 20x earnings instead, then the same company will increase in value from £100 million to £200 million without increasing its earnings.

If in contrast they were happy to pay 15x earnings in the past, but will now only pay 9x earnings, then the value of the same company will fall from £150 million to £90 million.

That’s partly what’s happened with emerging markets, versus developed markets like the UK. Yes, business is booming in countries like India, but investors have also decided they’ll pay much higher prices to access that growth, too.

As a result, the Indian market has re-rated and is now on a pretty high price-to-earnings ratio of 22. In contrast, the UK market is on a P/E of around 14, with the US market on 16, according to FT data.

Blue chip companies in the US used to command a much higher rating than risky and volatile emerging market ones, which were on lower ratings. Who is to say that won’t ever be the case again?

Valuation really is key. An excellent report from The London Business school found that because investors in high growth countries are prepared to pay more for such shares, they frequently suffer worse returns, when earnings fail to match the most optimistic projections.1

In contrast, paying a cheap price for average growth often yielded at least as good returns.

Enter the emerging market index fund

None of this is a reason to shun emerging markets, but just a reminder to invest cautiously.

I fully believe in the globalization big picture. Environmental catastrophe aside, India, Africa, and South America will still be producing aspirational middle-class graduates long after you and I are drawing our pensions!

  • Personally, I invest in emerging markets directly via the Templeton Emerging Market Investment Trust.
  • I also invest indirectly by backing big companies such as Unilever, who now get most of their growth from the emerging world.
  • I own shares in fund managers directly targeting Western investors eager to put money to work in the region.
  • In the past I’ve traded emerging market ETFs, and I would do so again.

However trading costs with investment trusts and ETFs add up, especially if you’re an investor of modest means.

Also consider the history of booms and busts in emerging markets. I think another bubble is brewing, but I’ve no idea when it will burst – it could easily be several years away. And when it does burst it’ll probably leave emerging market shares cheaply rated, and so good value.

The best way to invest into volatile markets like this for most people is through regular monthly savings, and that’s where an index fund is ideal. Unlike with ETFs you don’t pay trading fees, and by saving every month you benefit from averaging into your investment.

As far as I’m aware, the new L&G emerging markets index fund is a first for UK investors. It was only launched at the end of October. You can read more about the index it tracks on the FTSE website.

The total expense ratio is estimated at 0.99%, which is high-ish for a UK index fund these days, but not massively more expensive than other emerging options. The iShares emerging markets ETF has a TER of 0.75%, while the Templeton Trust I hold has a TER of 1.3%.2

I like, use, and have recommended L&G’s platform in the past. Partly it’s out of habit (its index funds are no longer the very cheapest) but also I like how easily I can switch between its different index funds for free.

I’ll be adding the new emerging markets index fund to my mix. But I’ll be keeping one eye on the exit!

Click through for more information about the emerging markets index fund.

  1. Among other reasons – for instance they also found that in emerging countries the state and its citizens often claim a greater share of the profits of economic expansion than in developed markets, to the detriment of shareholders []
  2. The Templeton trust manager would doubtless claim he can find bargains for his extra money, and indeed there is some academic evidence that emerging markets are less efficient. You can also make regular savings of as little as £50 into the trust, via its savings plan. []
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{ 6 comments… add one and remember nothing here is personal advice }
  • 1 Frugal December 2, 2010, 1:38 pm

    Interesting read, though I think I’ll stick to a mix of HSBC index trackers and ETF. What do you think about India Capital Find and Utilico Emerging Market trusts to spice things up a bit?

  • 2 pkora94 December 2, 2010, 6:58 pm

    Would love to know what monevator`s portfoilio looks like in terms of asset allocation and performance against any particular benchmark. I have been holding a large exposure to emerging markets equities, up to 35% and have recently been increasing exposure to Japan and uk equit income. Getting a bit nervous about EM exposure but expecting a santa claus rally so keeping on hold.

  • 3 The Investor December 3, 2010, 12:24 am

    @Frugal – I’m not familiar with those Trusts to be honest. Templeton Emerging Markets Investment Trust has been very good to me. Personally I wouldn’t add just one country specific Trust to your mix, as you’re taking an unnecessarily risk on that country doing well, when what you’re really trying to add is emerging market exposure. If you’re buying and holding ETFs (as opposed to looking for a fund) with sizeable sums, then iShares have a fair few options.

    @pkora94 – I did kick around the idea of going ‘full disclosure’ back in the middle of 2009, but I decided not too for a many reasons, not least of which is I’m inherently quite a private person. Beyond that:

    Firstly, I was worried doing so would constrain what I do with my portfolio. (For instance, I might cling on to positions I’ve defended on here, or similar, or buy stuff partly because I want to write about it, or similar). While I love sharing my thoughts with you all, this blog makes a trivial amount of money compared to the fluctuations in my net worth caused by trading/investing, so that’s just too much of a risk!

    Secondly, I also wouldn’t actually want to suggest to people that they invest exactly like me! 😉 I’m not quite so worried about this now that The Accumulator is on-board and sharing his sensible thoughts on a pure passive approach. That’s like to be a far better approach for most people, going on the evidence from academics. I’d suggest anyone who fancies more active investing sets aside say 10-20% of their portfolio for the purpose, though, and ring fences it. It is an engaging challenge.

    Thirdly, I’m wary of benchmarks for all sorts of reasons. I’ll have to write a post about this soon, as me and The Accumulator have been discussing it too.

    Fourthly, I’m wary about being seen or presenting myself as some sort of mini-Warren Buffett. While I am ahead of where I’d be if I was purely passive with roughly the same asset class allocation, I’m not convinced as to why, yet. Sometimes of my stock picks in the active part of my portfolio languish or even plunge like anyone else’s, and I’ve also done well moving money in and around the various markets in recent years (e.g. Into and out of cash, or Japan) – and that’s hard to define as a strategy.

    Finally, that’s not really what I want this blog to be about. It’s about telling people how to take control of *their* investing, not giving them yet another person to think has some specific blend of ‘secrets’. I hope people become better investors by reading about investing here — I don’t claim to be purveying a recipe for outperformance though. 🙂

    For a short and deliberately vague summary of where I’m at though, as mentioned a few times I have been extremely long equities for 18 months now. I’m currently very biased towards UK equities, but have about 15 to 20% overseas. My passive allocation is the lowest it’s been for years – less than 15% or so now, compared to a more typical 50%. I’ve got no government bonds and haven’t held any since late 2008. I have a couple of preference shares, and a bit of cash. I have stuck with those commercial property REITS that you may recall I started buying in mid-2009. I have gradually tilted much more towards more defensive investment trusts and stock picks with decent dividends, not really because I’m bearish (I’m *still* very bullish on equities at these levels) but because that’s what lets me sleep at night being 95% invested in the markets! But I also hold recovery punts like Lloyds, and some small cap growth stocks, too.

    While I’d say I’ve had a good (and fortunate!) bear market, I have missed tonnes of opportunities in the past two years and kick myself for it. For instance – and to return to the post subject – I considered going overboard on Templeton Emerging Markets when it was languishing at irrational lows, and bottled out. Similarly, I sold out of some excellent picks like Anglo Pacific (a geared play on mining, basically) for good gains, but missing out on a three-bagger!

    I think your UK equity income is a good place to be currently, and Japan does (as so often) look a bargain. But really it’s hard to argue with just owning a tracker currently — everything except resource stocks look at worst fairly valued, and in some cases still quite cheap, and the world is definitely on the mend.

    Just this week we saw UK PMI figures at a 16-year high! And they laughed when I said British industry was recovering fast back in February. 😉

  • 4 Marc December 3, 2010, 7:32 am

    @The Investor – Post & comment of pretty epic proportions there! Another consideration to make is that executing foreign share purchases costs significantly more from some brokers/platforms (£1.50 for UK shares but £15 for “foreign” from iii, x-o are UK only, TDW for £12.50).

    I suppose you may need a split of brokers/platforms, those who are cheap on UK shares don’t seem to be the best for international dealing necessarily.

    Then there are the issues of brokers taking forex commission / conversion spread. I’ve never bought foreign shares, but have been researching into it. The situation gets rather mucky, with rather a lot of people taking sizeable slices of pie for themselves as the pipeline is extended.

    How do you handle the situation? If you trade frequently in a given country do you set up a bank account in that nation (e.g. USA) and then use a more competitive forex broker (like CurrencyFair) to get a significantly better conversion rate?

    Good call on your portfolio (semi) anonymity – it helps avoid confirmation bias and putting your investments at risk for some unknown entities staring into computer screens ;-). Ultimately that’s better for you and the reader, I think.

  • 5 Tony December 3, 2010, 1:30 pm

    Excellent post and comments.

    I understand and your position on portfolio anonymity. If you’re not careful, you’ll end up like the Motley Fool with their “these are the 3 great shares you should have bought last month” articles – vaguely interesting, but also frustrating!

    In addition, each reader’s attitude to risk, requirement for growth/income, etc is different.

  • 6 The Investor December 5, 2010, 4:21 pm

    @Marc – Sorry, I wasn’t clear. When I say moving money into Japan, say, I invariably mean using for instance Legal and General’s index switching facility. I’m not at a level where I need or could sensibly afford the cost of directly banking in other countries just for trading purposes. And withholding tax has made me avoid buying shares directly in markets like the US. I don’t think I’d bother until my portfolio reached the multiple millions to be honest, and with the possible exception of some ‘Armegeddon’ funds stash in Australia or Switzerland, say.

    Thanks for your thoughts, and appreciate the note of support about the anonymity.

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