GEMs are Out of Fashion—That Might be Good

Using the Lipper Leaders scoring system to analyse the best-performing funds in the IA Global Emerging markets sector.

Global emerging markets have had a torrid time. In a world where all the action seems to be happening in a few (and ever fewer, as the Magnificent Seven shrinks to the Fantastic Five) stocks, investors have been lulled Stateside.

Emerging markets, on the other hand, seem to have had little to recommend them. They’ve lagged developed market indices for years, so why take the additional risk that’s perceived to come with this asset class? What’s more, China has grown to be an increasingly important, if not the major, component of emerging markets, one which other emerging markets were themselves increasingly correlated. China has, however, over the past few years struggled to recover from COVID, faced major obstacles around its property market and tech companies, to the extent where many see it as “uninvestable”.

The sector is up 9.4% to the end of May, lagging considerably the deeply unloved UK, and down 8.3% over three years. As a result, it has shed more than £7bn over the past year, as investors sought harbours that were both safer and more remunerative.

There are also wider risks, were that not enough. Deglobalisation remains a threat to trade, and a re-election of Donald Trump as US president would likely see that exacerbated, as we have already seen between the US and China previously, with the raising of eye-watering tariffs. But this is a two-edged sword, as the opposite of offshoring – which has pushed global growth over the past decades – isn’t necessarily onshoring, where business face the cost pressures they adopted offshoring for in the first place. It can equally be ‘friendshoring’, the rerouting of supply chains to more amenable jurisdictions. Mexico is, of course, a case in point, and it’s not the only one.  While this creates uncertainty, it also creates potential opportunities for those investors ahead of the curve. And then, of course, the true contrarian may well feel the case against China overcooked, and the market a bargain.

Additionally, many emerging markets weathered the rising interest rate environment much better than predicted, are in relatively good shape fiscally, and growing faster than developed markets. One can also argue that the underperformance of recent years makes them cheaper, trading on much lower valuations than developed market equities in general, and so a more attractive buying opportunity in an asset class in which most investors are underweight.

I’m a tad sceptical of this approach: over the long term it’s probably right. Probably. But, as the old adage goes, in the long term we’re all dead. A structural case isn’t the same as an intelligent entry point. There’s also the double-edged question centred around the US: if it keeps on rallying, which EMs, at a country and sector level, stand to benefit? On the other hand, if and when the increasingly narrow US rally runs out of steam, which EMs would offer a refuge, or even benefit? The answers to these two are, inconveniently, unlikely to be the same.

The world is wide, and emerging markets are still the most of it, if not by GDP, then by population and size.

Although I’ve bemoaned the returns in the sector, as ever it depends on with whom you are invested. Three-year returns range from 26.49% to almost negative 40%. The latter fund is heavily focused on Chinese tech, so this really shouldn’t surprise anyone. What is more surprising is that the top two funds are WisdomTree ETFs: the first, WisdomTree Emerging Mkts Equity Income UCITS ETF, having 33% in Taiwan (and more surprising still, a top holding isn’t Taiwan Semi-Conductor), with the WisdomTree Emerging Mkts SmallCap Dividend UCITS ETF having a similar if smaller Taiwan allocation and, as the name suggests, a small-cap bias. Both have an orientation to income, and so a value bias. Both are quite niche plays, with low Lipper Leader consistent return scores, so likely not pitched at someone looking for diversified EM exposure.

While having a higher China weighting, Artemis SmartGARP Global Em Mkts Equity (and with Taiwan Semiconductor as its top holding) comes in third and has a consistent return rating of 5 – Lipper’s highest.

There’s a high proportion of funds with small- and mid-cap biases in the table, however, which indicates what’s been driving the market of the three years. Likewise, there’s a clear value tilt, which challenges the old assumption that EM equals growth.

Table 1: Top-Performing Global Emerging Markets Over Three Years (with a minimum five-year history)

All data as of May 31, 2023; Calculations in GBP

Source: LSEG Lipper

This article first appeared in the March edition of Moneyfacts (p15)