After nearly four years of disappointing performance, many investors have fallen out of love with diversified emerging market funds. G. Rusty Johnson, co-lead manager of the $2.4 billion Harding Loevner Emerging Markets Fund, thinks it may be time to think about a reconciliation.
“The market has been focusing on the negative developments in emerging markets, which have been very real and numerous,” he says. “But there is also room for optimism. The emerging market pendulum seems to be swinging in the right direction.”

Such a swing would be welcome relief for emerging market investors plagued by setbacks since the markets peaked in 2010. For several years, slower growth, corruption and pollution have dominated headlines about China. Last year, Russia and other emerging market economies tied heavily to commodities were hit hard by falling oil prices and OPEC’s surprise decision not to curtail production. In Brazil, adverse political developments contributed heavily to the sharp falls in the country’s currency and stock market. And the strengthening of the U.S. dollar against many emerging market currencies meant that foreign currency returns translated into fewer dollars for U.S. investors.


Johnson says some of those headwinds show signs of abating. At some point, the dollar’s unprecedented run will moderate. Countries such as China and India, which make up a large swath of the MSCI Emerging Markets Index, should continue to benefit from low oil prices because they free up disposable income for citizens of these increasingly consumer-oriented economies. Areas hit hardest by low oil prices, such as Russia and a few countries in Latin America, make up a much smaller percentage of the index and the fund than those that stand to benefit from them.

Some countries are seeing progress on the political and regulatory fronts as well. In China, which represents about 23% of the MSCI Emerging Markets Index, a new government is improving economic efficiencies, addressing government corruption and tackling pollution through financial and tax policies that favor natural gas and mass transportation over cars. In India and Indonesia, equity markets responded favorably to the election of reform candidates.

To some, positive trends for emerging markets go beyond structural and political reforms. In a March article in Canadian newspaper The Globe and Mail, wealth manager Thane Stenner noted that over the last two years investors have been pulling huge amounts out of emerging markets equity funds. To contrarian investors like him, such pronounced and prolonged outflows indicate “it’s generally a time to buy before the asset comes back into favor.” He also pointed out that over the past 25 years the market has only been down three years in a row during the period between 1999 and 2001, and the subsequent upturn was sharp.

Even if stock prices recover, political and economic improvements are moving forward at a different pace around the world, a trend that has become particularly pronounced over that last couple of years. In countries such as China and India, political reforms and lower oil prices sent markets higher in 2014, while oil exporters such as Russia have suffered severe market losses.

Unlike some emerging market funds, this offering usually doesn’t make big country or regional bets in an attempt to cash in on these differences, since those bets can sometimes backfire. According to its latest fact sheet, country weightings landed no more than 8 percentage points above or below the benchmark index weighting. In terms of sector exposure, the fund is slightly overweight to the benchmark in health care, consumer discretionary and consumer staples stocks and underweight in commodity-sensitive materials, utilities and energy companies. The underweight position in the last sectors came from weak returns as well as the sales of select energy positions late last year, including Brazil’s Petrobras and Ecopetrol of Colombia.

The fund’s frontier market exposure has also shrunk, from a high of nearly 16% last year to about 7% today. One-third of that loss stemmed from the MSCI benchmark’s reclassification of Qatar and the United Arab Emirates as emerging market countries. The rest came from the fund’s sale of two stock holdings. The fund also modestly increased its exposure to Russia at the end of 2014 as the falling stock market there dragged down some good, well-valued companies with it.

Even though Johnson and his team take economic and political conditions into account, stock selection remains their dominant tool for beating the benchmark. The portfolio holds around 80 stocks, which is fairly concentrated for an emerging markets fund. To qualify for inclusion in the fund, companies must have qualities such as a clear competitive advantage, strong management, little or no debt and potential for growth. The turnover in the fund is a relatively low 28%.

This measured approach has insulated the portfolio somewhat, which has returned 9.84% on an annual basis for the 10 years ended April 30, from emerging markets volatility, according to Morningstar analyst William Samuel Rocco. In a report on the fund, he noted, “Although [the fund] has struggled to keep up in go-go rallies due to the managers’ price consciousness and quality orientation, it has generally held up well in downturns for the same reasons and it has often outperformed in moderate upswings. As a result, this fund boasts terrific long-term risk-adjusted returns.”

The kinds of high quality companies Johnson favors aren’t particularly cheap right now, and like their developed market counterparts, emerging market blue chips have risen to fairly high valuation levels during risk-wary times. Nonetheless, Johnson maintains it’s still possible to sift through the investment universe to find good, attractively valued, high-quality, growing companies.

“The perception is that emerging markets are a basket case that have gone through a difficult time,” Johnson says. “But there are a lot of solid, growing companies as well. Things are better at the company level than the country level.”

He cites Egypt’s CIB (Commercial International Bank) as one of those solid companies. Amid political upheaval, the bank, which was added to the fund in the first quarter of this year, has managed to become a leader in Egypt for its profitability, its number of customers, its market capitalization and its loans and deposit market share. Johnson says that with a new pro-business government regime in place, CIB could see an upturn in corporate borrowing.

Other new names added to the fund in the past few months are AirTac, a Taiwanese company that produces pneumatic factory automation equipment, primarily for mainland China, and Bancolombia, a leading Colombian bank. AirTac, the second-largest company of its kind in the world, sells most of its products in China and fits well with that country’s move from labor-intensive production and manufacturing to automation.

Bancolombia, which has been in the portfolio before, has focused on improving the quality of its loan assets and is finding renewed growth prospects with infrastructure lending. It has also boosted its presence as a lender to small and midsize businesses, a growing part of the country’s economy.

Late last year, the fund added modestly to positions in durable growth businesses in Russia. Even though the country is suffering from lower oil prices, such businesses should generate strong returns on capital and have the staying power to endure bad times. Russian holdings fitting the bill include discount grocer Magnit. The chain provides good value and choice to Russian consumers, whose discretionary income will likely continue to fall this year as inflation induced by international sanctions against the country takes its toll. The business, which services 8,000 stores with a fleet of 5,500 trucks, operates with no net debt.

The fund has been underweight in China since the early 2000s, largely because of the dominance of state-owned enterprises, which critics say lack transparency and are often managed to implement government policy and achieve social and political goals rather than to create shareholder value. Often, the fund will substitute Hong Kong-listed companies as a proxy for Chinese companies. According to the latest fact sheet from February, the fund’s stake in China and Hong Kong was 17.6%, while the benchmark index’s stake in China alone was 22.2%.

One of these companies is AIA Group, a Hong Kong-listed life insurer and one of the fund’s top 10 holdings. The company offers low-risk exposure to China’s financial services industry without a direct link to the state-owned banking sector. “A lot of insurance in China is sold as a savings product,” says Johnson. “As Asians gather more assets, the concept of covering risk through life insurance is catching on, and there are not many big players in the field at this point.”

China Mobile, the country’s telecommunications giant, is one of a handful of state-owned enterprises the fund does own. Johnson, who added to the position earlier this year, says recent reforms have improved governance and reduced the corruption at state-owned enterprises, and that the company has a growing subscriber base, lots of free cash flow and the ability to increase dividends.