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Emerging market funds no longer a passport to riches

Experts wary of prospects for the former market darlings, at least in the short term

It isn't an easy time to be in emerging markets. The selloff that began in 2013 continues unabated, with investors fleeing emerging-market mutual funds and exchange-traded funds (ETFs), which less than two years ago were the darling of the investment world.

"It was hard to lose money last year," says Craig Basinger, chief investment officer of the Investment Management Group at Toronto-based Richardson GMP Ltd. "U.S. markets did well. Europe did well. Japan did really well. Emerging markets were one of the only bad places to be."

"You think back over a year ago and emerging markets were viewed as the place to invest in by a lot of forecasters," adds Jon Palfrey, senior vice-president at Leith Wheeler Investment Counsel Ltd. in Vancouver. "They were the ones viewed to lead the global recovery."

That was then, this is now. As of last Friday, the benchmark MSCI Emerging Markets Index was down 6.4 per cent this year. Richardson GMP, which tracks the largest emerging-market funds, reported on Friday that these funds dropped 5 per cent last year and 7 per cent so far this year.

So what is an investor to do? Should you invest in emerging markets now - and if so, should you consider a broad-based fund or target specific countries or sectors?

Enter cautiously, warns Mr. Palfrey, but don't avoid emerging markets altogether. They are a good way to diversify portfolios - "but, from our point of view, 5-per-cent [exposure] is the maximum for our clients."

Most investors, he says, have emerging-market exposure already, in Canadian resource stocks or U.S. consumer and technology stocks. Those companies, the stalwarts of many funds, often sell into emerging markets or use them to produce goods.

If you're going to invest, Mr. Palfrey says, do so with a broad-based mutual fund or ETF, with exposure to a number of countries and through a company with a proven track record. And expect to pay more, he adds: An emerging-markets ETF would have about a 65-basis-point fee and an active mutual fund would run about 2.3 per cent, more than the average fee.

Mr. Palfrey is no fan of country-targeted funds, calling them problematic. Managers who run them are forced to invest the money, even if there isn't always something worthy to buy. "It's just too restrictive. It's tough for someone to decide if Vietnam is going to outperform here or there. It's a hard call to make."

Tyler Mordy, president of Hahn Investment Stewards & Co. Inc. in Kelowna, B.C., sees things differently. He believes investors should target their emerging-market investments to select countries, and avoid broad-based funds.

"They are tilted towards yester- year's winners," he says about multicountry funds, with weightings on countries like Brazil, a resource- and export-dependent market that was once a model for emerging markets but no longer.

Instead, Mr. Mordy favours countries such as Poland and India, which he calls "the new models" - countries that create strong economies through good structural policies and by increasing consumption at home.

"I would say for the average retail investor, I think you could select a few countries and get country ETFs to put in your portfolio," Mr. Mordy says.

Kevin Gopaul, senior vice-president and chief investment executive at BMO Global Asset Management, agrees there are times when investors should consider country ETFs, but adds "you really have to understand the economy you're investing in."

If an investor wants to play demographic changes in a country - the growth of the middle class in India or China, for example - buying a targeted fund makes sense, he says.

However, doing so now, amid selloffs and a number of currency issues, could be tricky.

"I do believe in emerging markets," Mr. Gopaul says, but cautions, "there's a lot of sentiment and inertia driving the markets down right now."

For Nick Chamie, chief investment officer for international wealth management at Bank of Nova Scotia, China, South Korea and Mexico are countries "where we think the fundamentals make sense."

He suggests avoiding countries with large trade deficits or those that are too reliant on foreign capital.

Over all, Mr. Chamie says Scotiabank expects emerging markets to underperform for the foreseeable future.

Mr. Basinger of Richardson GMP agrees about emerging markets in general. "We've been negative and we're staying in that camp," he says.

Developing countries are experiencing falling economic momentum at a time when growth is improving in developed countries, particularly the United States, Japan and a lot of Europe, Mr. Basinger says. Emerging markets have become reliant on fund flows, and now that funds are flowing in the opposite direction, these economies are starting to show their weaknesses.

Still, Mr. Basinger says developing countries have done very well since the 1990s, and will do better in the long-term, helped by growth in developed countries.

"A time to buy will come," he says, "it just isn't yet."

© 2007 The Globe and Mail. All rights reserved.

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