Is it time to exit emerging markets investments?

Investors may well be sitting on losses from emerging markets funds. Is it worth keeping the faith for a sustained recovery or is worse yet to come?

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Emerging markets have significantly underperformed compared to other sectors over the last few years. The MSCI Emerging Markets Index fell by 2% in 2021, 24% lower than the developed markets MSCI World Index return. With market volatility showing little sign of abating, is it time for investors to cut their losses on emerging markets investments?

Well, Larry Light from Fortune.com believes that “Emerging markets are poised to have a breakout year, and compared to US equities these stocks are shockingly cheap.” He states that “Red ink is washing over emerging markets, which haven’t been doing a lot of emerging lately” but, to some, “that spells opportunity.”

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Let’s take a closer look at the outlook for emerging markets, together with some of the top-performing funds.

Why have emerging markets underperformed?

Emerging markets were one of the better-performing sectors in 2017, delivering a 24% return according to Trustnet. However, concerns over global economic growth and US-China trade relations started to take their toll thereafter. The pandemic struck a further blow, with disruption to global exports and slow vaccine roll-out in some emerging economies.

The issue of high inflation has not been confined to developed economies. Darius McDermott from Chelsea Financial Services comments that the “sharp spike in emerging market inflation hampered many economies in 2021” with central banks having “to jump the gun rather than hope that price rises and supply bottlenecks were temporary.”

As one of the largest emerging markets, China has also exerted a drag on returns. According to Lazard Asset Management, China’s “barrage of regulations over the past year and Beijing’s drive for ‘common prosperity’ have led to market value losses of more than $1 trillion (£77 trillion) and raised doubts about the country’s commitment to a market-based economy.”

Due to these factors, the emerging markets sector has achieved a three-year return of 10%, including an 11% loss in the last year.

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What’s the outlook for emerging markets?

It would be fair to say that opinion is divided about the outlook for emerging markets.

Victoria Scholar from Interactive Investor points to two main risks for emerging markets. The first is that emerging markets “with lower vaccination rates are more likely to be at risk from the Omicron variant”, including Russia, India and Mexico.  

She adds that the “strengthening US dollar, underpinned by monetary policy normalisation from the Federal Reserve, is likely to be a key risk to emerging markets in 2022”.

However, this sector encompasses a wide range of countries and industries. While India, UAE and Saudi Arabia out-performed in 2021, Turkey, China, and Peru were at the bottom of the sector.

Schroders reports that “China’s economy made a blistering start to the year” but warns that “financial markets are already pricing in tougher times ahead.” Issues include stagflation reducing demand for manufactured goods and the recent rise in Covid-19 cases.

On the other hand, Latin America has benefitted from rising commodity prices. Justin Leverenz from Invesco comments that “the rise of disruptive technology could help underwrite a better chapter for the region and represent a big opportunity for investors.”

In summary, the consensus view is that emerging markets may face further volatility in the short term but have upside potential in the longer term. Darius McDermott states “Like most parts of the world, emerging market valuations are not cheap relative to history, but they are nowhere near as expensive as the likes of the US.”

What are the top-performing funds?

These are the top three emerging markets funds based on their five-year performance.

1. Aubrey Global Emerging Markets Opportunities

This fund has rewarded shareholders with a five-year return of 58%, according to Trustnet. But it’s been a bumpy ride with losses of 11%-13% in 2018 and 2022. Its portfolio focuses on large-cap growth stocks, with over 80% invested in India and China.  

2. BNY Mellon Global Emerging Markets

BNY Mellon Global Emerging Markets delivered a five-year return of 51%, as reported by Trustnet. Over half the fund is invested in China and India, together with the IT and financial sectors.

It’s consistently outperformed the sector, and it achieved a 55% return in 2020 compared to a sector return of 14%. However, it’s also suffered greater losses than the sector, including a fall of 20% in 2018.

3. Baillie Gifford Emerging Markets Leading Companies

Trustnet reports a five-year return of 44% for this fund. However, it’s fallen by 20% in the last year. Around half of the fund is invested in China and Brazil, along with IT and financials. It’s also a more volatile option, with losses of around 8%-11% in two of the last five years.

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Take away

Emerging markets funds have performed poorly over the last few years. And uncertainty over the sector outlook appears likely to continue in the near term. That said, Investors Chronicle comments that “Investors in emerging markets are sometimes very well-rewarded for taking on risk” with annual returns of over 50% in some years.

If you’re looking for an ISA platform, it’s worth reviewing our top-rated ISA providers.

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