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:

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. [↩]

There aren’t enough low-cost index funds available to UK investors. This comes as a shock when you’ve read all the books proclaiming passive investing to be easy – just pick some recommended index funds to cover the main asset classes, batten down the cost hatches, and settle in for the long haul.

But those books are American. In America, trackers are as cheap and plentiful as burgers and cars. It’s much harder to put together a decent passive portfolio in the UK – especially if you’re a small investor.

If you’ve only got a few hundred pounds to put away every month and you need the discipline of drip-feeding, then you’re up against two big problems.

Problem 1: How to diversify

Most UK index funds cover domestic equity – the famed FTSE 100 or All-Share indices. Beyond that, few market segments can boast two funds, or even one.

Be reassured: You haven’t missed some secret valley of the index funds where other passive investors are partying. The choice really is miserable.

I know a number of people who’ve been stopped in their tracks at this point and given up on their DIY investing dreams.

Problem 2: Trading fees

ETFs are the recommended alternative. Fill your boots. ETFs are as common as kebab vans.

But ETFs present a big problem for small investors. The flat-rate trading fees play havoc with small investment sums. And while Vanguard’s cut-price index funds offer another route to salvation, that way too is blighted by trading fees.

The solution is a no trading fee portfolio:

The No Trading Fee portfolio

Even with our limited UK choices, you can rig up an index fund-only portfolio that’s reasonably diversified and avoids trading fees. It’s not perfect, but it’s good enough to get a small investor started and way better than giving up.

My suggested portfolio contains the following recommended index funds:

Domestic equity
HSBC FTSE All Share Index – TER1 0.27%

UK gilts
L&G All Stocks Gilt Index Trust – TER 0.25%

UK index-linked gilts
L&G All Stocks Index Linked Gilt Index Trust – TER 0.25%

Developed world ex-UK equity
HSBC American Index – TER 0.28%

HSBC European Index (excludes UK) – TER 0.37%

HSBC Japan Index – TER 0.28%

HSBC Pacific Index (excludes Japan) – TER 0.37%

Why I’ve suggested these funds

The domestic equity and bond fund choices are straightforward, and offer a solid foundation for a passive portfolio.

The next move is to diversify equity beyond Blighty’s shores. The only way to do this and avoid trading fees is to roll your own developed world equity (excluding UK) fund. Mine here is built from individual HSBC index funds that cover all four corners of the developed world when combined.

Happily, the TER averages out at a reasonable 0.325%2, which is less than the nearest equivalent ETF and only slightly more than Vanguard’s all-in-one fund (VVDVWE) that rocks a 0.3% TER.

Mix according to an index

How you divvy up your portfolio depends on your goals and attitude to risk. But whatever amount you decide to invest overseas, your developed world equity mix should take its cues from an appropriate index.

For example, Vanguard’s VVDVWE fund tracks the ‘FTSE All World Developed ex UK index’ and offers the following guide:

• 56% US
• 24% Europe ex UK
• 10% Japan
• 10% Pacific

Greater diversity

Once you have your standard No Trading Fee Portfolio up-and-running, the next move would normally be to diversify into property or emerging markets.

But in the UK it isn’t currently possible to invest in a property tracker without turning to ETFs.

One answer is to save a proportion of your investment funds in cash every month until you’ve accumulated a decent lump sum. Then invest the whole lot into a property ETF in one go. This reduces the impact of trading fees as a percentage of the money you invest.

While drip-feeding is a useful technique, its real potency is as a psychological aid rather than as nitro for your investing returns. There’s no need to be exclusively wedded to the idea.

The cheapest emerging markets option is Vanguard’s VIEMKT index fund. The usual trading fee caveats apply, but again, you can use lump sums to deal with this.

However, hot off the launch pad comes L&G’s Global Emerging Markets Index Fund. It seems expensive, with an estimated TER of 0.99%. But as you don’t need to pay trading fees, the cost differential between this fund and its competitors is fairly minimal.

With the ink barely dry on the factsheet, the fund’s asset holding and performance data are sketchy to non-existent right now. I’d let this one settle down first, but at least it shows that the UK index fund market isn’t totally inert.

Where to buy

To put the plan into action, get a stocks-and-shares ISA from a broker or fund supermarket that doesn’t charge trading fees for funds (most don’t) or an annual management charge (many do, but avoid them by using the links above).

You could fall foul of £50 per fund minimum contributions, depending on your monthly investment sum. So keep in mind, you don’t have to buy every fund at once. You could buy one or two funds until you’ve reached your asset allocation target, then switch to fill up the rest.

And finally…

If the whole developed world equity workaround feels like a fag, then I’ve got one final suggestion.

You can buy developed world and emerging market exposure in one ETF swoop with db x-tracker’s FTSE All-World ex-UK (XWXU).

The TER is 0.4% and if bought via a regular investment scheme then trading fees can be slashed to £1.50. That would amount to a reasonable 0.5% initial cost, if you invest £300 per month.

No one said it was gonna be easy. Apart from the books.

Take it steady,

The Accumulator

1. Total expense ratio – see my previous warning about high TER hazards [↩]
2. Non-weighted [↩]

The best money reading on the Web, rounded up for your pleasure.

Now that politics is firmly back on the media agenda, I’m stepping back. Nothing if not contrarian! Instead I’ll refocus Weekend Reading back towards highlighting a particular article of the week, before the usual link roundup.

Will I rant again in the future? Indubitably.

But I think (guess!) that most people read Monevator for investing insights. While I consider an element of macroeconomic and political crossover worthy of consideration, spending time on the detail of your strategy – such as The Accumulator’s recent guide to withholding tax – is more likely to make you money. Yet I suspect most of us put the focus the other way, ranting at the numbskulls on Question Time once a week, but checking our pensions once a year.

For one thing, as Larry Swedroe reminds us in my post of the week, short-term economic noise is a terrible guide to future returns.

Swedroe quotes Warren Buffett, who said:

“We have long felt that the only value of stock forecasters is to make fortune-tellers look good. Even now, Charlie (Munger) and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”

Buffett certainly believes he can predict the future earnings of a company over the medium to long-term. Backing his faith has him jostling with best friend Bill Gates for the title of World’s Richest Man.

[continue reading…]