Emerging markets sometimes feel like they’re still emerging, which can leave financial advisors and equity investors deeply frustrated. Brimming with the promise of youthful demographics and high-ceiling economic growth, this smorgasbord universe of countries with disparate political and economic structures has often failed to live up to the hype.

Emerging markets arose as a distinct asset class more than 30 years ago when the MSCI Emerging Markets Index was created with 10 countries (excluding China). At its formation, it contributed less than 1% of the MSCI All Country World Index. Today, this emerging markets index represents 26 countries (China made up a whopping 43% as of October), contains nearly 1,400 constituents and comprises 12% of the MSCI ACWI.

There have been heady times for emerging markets, as in 2006 and 2007 when China’s voracious appetite for raw materials was like a hurricane force tailwind for nations that supplied them. This enabled the MSCI Emerging Markets Index to trounce the MSCI ACWI and MSCI World indexes, the latter focused on developed markets in North America, Europe and Japan. But there have been recent lean years—such as from 2013 through 2015, and again in 2018 and 2019—when emerging markets underperformed as a group.

The main emerging markets index was slightly positive and had slightly outperformed the two above-mentioned indexes this year through October. But investment managers at actively managed emerging markets funds say investors should look beyond the index if they want to capture this segment’s most compelling growth opportunities.

“I know people haven’t looked at EM in a while, but I think they’ll be shocked when they start investing in the emerging markets,” says Dara White, global head of emerging market equities at Columbia Threadneedle Investments and co-portfolio manager of the Columbia Emerging Markets Fund.

He acknowledged the emerging markets space is dogged with the reputation of being very cyclical and dominated by energy, commodities, industrials and banks. “The opportunity set is so much different today,” White says. “The universe is dominated by IT companies, [technology] platform companies, communications companies … companies that provide a really good return on invested capital and understand the concept of shareholder return and have strong business models.”

The Columbia Emerging Markets Fund’s top five holdings are stacked with familiar names including Alibaba Group Holding Ltd., Tencent Holdings Ltd., Taiwan Semiconductor Manufacturing Co. Ltd. and Samsung Electronics, along with a semi-familiar name in Indian conglomerate Reliance Industries. China held a 36% weighting in the fund as of the third quarter, which was underweight China’s position in the MSCI Emerging Markets Index. Elsewhere, the fund’s 12% stake in India was overweight the index by roughly 50%, and its 7.3% positioning in Brazil exceeded the index by about 60%.

“The opportunities in Brazil are night and day compared to five years ago,” White explains. “Most of the Brazilian companies I own weren’t listed then—companies like Stone [StoneCo Ltd., a financial technology solutions company], Afya [Afya Ltd., a medical education group] and Localiza [a car rental company]. These are exciting growth companies run by entrepreneurial management teams. You don’t have to buy Petrobras, Banco do Brasil and Vale anymore.”

Valuations
The Columbia Emerging Markets Fund has outperformed its bogey during the last three-, five- and 10-year periods, and was up roughly 22% this year as of early November. But the success of the fund’s holdings has boosted valuations and made it much pricier than its benchmark index in terms of price-to-earnings and price-to-book metrics.

“We are very comfortable with the valuations of the secular growers within the EM universe,” White says. “The overall valuations of these companies are not too demanding—the more important part of the story is these are businesses that are still in the early innings of their earnings stories versus their developed-market peers.”

According to a late-October report from UBS, EM equities were trading at 15 times forward price-to-earnings and 1.8 times price-to-book ratios—much higher than their historical averages, but at deeper discounts than their historical five-year and 10-year averages to developed market and U.S. equities. Which is why UBS said in its report, “We believe there is room for emerging market valuations to catch up with their developed market peers.”

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