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.”

Nonetheless, high-flying large-cap tech darlings dominate in many EM markets, much as they do in the U.S. And that concerns some investors. “Big-tech EM companies give you some diversification with customers, country and currency risk, but not that much,” says John Thorndike, portfolio manager at GMO. “There is a feeling these guys are the only ones who are going to win.”

He adds that investors should think differently from the indexes, particularly if they’re willing to take bigger country and sector bets. “Our forecast for EM value is [performance gains] approaching double digits,” Thorndike says. “They represent 30% of our global portfolios. A passive index-weighted portfolio would have them at 3% to 4%.”

Don’t Forget The Old School
Aditya Kapoor, co-portfolio manager of the Ivy Emerging Markets Equity Fund, waxes enthusiastic about the growth prospects in the consumer discretionary, information technology and communications services sectors that hold the biggest weightings in his fund. But he hasn’t forgotten the old-school commodity plays that formerly played a bigger role in emerging markets.

“We definitely skew toward growth and technology platforms,” Kapoor says. “I’ve never liked the commodity side of emerging markets, but when you look at the valuations there they are super attractive.”

He notes the commodity sector over the past 10 years saw relatively little investment and a lot of consolidation. “Because of that, supply is very constrained in commodities such as gold, copper and iron ore,” Kapoor says. “The balance sheets have repaired, and many of them pay high dividends with a lot of free cash flow. EM still has some of the best commodity producers, and we’re finding opportunities on that front.”

And, of course, he’s also finding opportunities in technology—and not just in China. “China is just one part of the EM technology story,” Kapoor says. “There are some interesting companies in Korea, and a few in Latin America.”

One of the Ivy Emerging Markets Equity Fund’s top 10 holdings is MercadoLibre Inc., an Argentine company that hosts online commerce and payments platforms in Latin America. Another top 10 holding is Yandex N.V., a Russian internet search engine.

“Regarding tech sovereignty, every country wants a national hero when it comes to technology platforms,” Kapoor says. Yandex has government support in Russia, he adds, because the country wants “national heroes that don’t have to depend on the U.S. or China.”

China Is Still The Man
It’s in China, though, where Kapoor sees the most alluring action. China takes up more than 40% of his fund, and he looks for companies that won’t get hit by the ongoing U.S.-China trade war.

“We’re trying to find trends that are more powerful than the externalities that dictate much of what happens in the world,” he says. “We’re trying to find brands in China that could become the next Nike of China.”

He notes that he and his partner at the Ivy Emerging Markets Equity Fund repositioned their thinking—and their portfolio—when the trade war heated up in 2018. “I think this rivalry between China and the U.S. is here to stay,” Kapoor says. “There’s not one trade deal that will make us forget about it, and this rivalry will be fought on the technology front in A.I., cloud computing, quantum computing, advances in biotechnology, etc. It’s an issue you can’t ignore, but we chose to not invest in companies that depend a lot on key U.S. technology.”

He adds that China’s economy is very big, diverse and dynamic. “Its mobile internet economy is more advanced than that of the West. There are a lot of innovative companies able to compete on the world stage despite higher tariffs. That’s because the supply chain is so efficient there. The manufacturing capability of China is unmatched; that’s why we haven’t seen a lot of production move out of China.”

Likewise, Michael Oh, portfolio manager at Matthews Asia, looks to China to help fuel the returns of the Matthews Asia Innovators Fund, essentially an emerging markets fund that he co-manages. As of the third quarter, the fund was overweight China by about 18% against its bogey, the MSCI All Country Asia ex Japan Index, and had big overweight tilts to the consumer discretionary, communications services and health-care sectors.

“China has a lot of innovative companies that are creating high value-added services and products for the domestic economy, and that’s where the exciting growth story is,” Oh explains. “China has shown during the past 20 years it’s able to develop companies able to serve domestic consumers.”

Pandemic
The Covid-19 pandemic originated in China, but that country and its northern Asian neighbors by and large have weathered the storm much better than the U.S. and Europe. Consequently, the Asian regional economy has recouped much of its pre-Covid levels. Still, the pandemic will continue to impact emerging markets for the foreseeable future.

“The pandemic is speeding up consumer behavior changes in China and other developing Asian countries by pushing them into using more online services,” Oh says.

He adds that the pandemic was a wake-up call for China to strengthen its health-care infrastructure, so Oh foresees health care as a boom market in the making there.

In its late-October report on emerging markets, UBS noted that Asian countries—except for India—generally have the Covid-19 pandemic under control while many other EM nations are still struggling with the virus’s spread.

“Growth recovery will likely be driven by further economic reopening, which will depend on the discovery of effective therapeutics and vaccines against Covid-19,” UBS said in its report.

It also stated that key risks to EM equities include growing U.S.-China tensions, a possible second Covid-19 wave leading to renewed national lockdowns, a stronger U.S. dollar, and the vulnerable fiscal accounts of EM economies following the rollouts of unprecedented fiscal stimulus packages.

“Covid will lead to fiscal pressures, and we’ll see the cost of the pandemic play out in different ways during the next few years,” Kapoor says. “China, Korea and Taiwan have spent a lot less than what the U.S. and some other countries have done. I think that’s a tailwind for those countries.”

And that speaks to the vagaries of emerging markets (of course, developed markets have their vagaries, too).

“It’s not like EM as a whole is great,” Kapoor says. “There are 1,400 stocks in our index, and we own 50 of them. We’d like to own more, but it’s hard because there are a lot of problems.”

Dara White from Columbia Threadneedle echoes that thought. “The big story is that emerging markets is a stock picker’s market and it’s a secular universe with a lot of high-quality companies,” he says, adding it also contains a number of countries investors should avoid.

“We’ve had no exposure to Turkey since the failed coup [in 2016],” he says. “We have no exposure to the Middle East in general. We have no exposure to Mexico. Turkey and the Middle East in particular is an area where politics make it almost uninvestable.”

All three emerging markets funds mentioned in this article have solid long-term records that have outperformed their bogeys. The somewhat similar nature of their portfolios in terms of sector allocations, country weightings and top company holdings conveys the message that less is more in emerging markets.

“The investable universe is the BRIC [Brazil, Russia, India and China] countries,” Kapoor says. “It’s Korea and Taiwan. And there are certain one-off plays in other countries. But for the most part, the investable countries is a much smaller subset.”