Few investors are eager to jump into emerging markets — for good reason. Most emerging markets stocks and funds have been clobbered. But that makes it all the more noteworthy for the emerging markets managers who avoided the collapse.
Here are investing tips from three of the emerging markets fund managers who have easily beaten the benchmark over the past year and rank among the elite emerging markets funds tracked by Morningstar. Their advice turns out to be advice that's applicable to all situations, especially in hot trades, where everyone is chasing the same performance.
1. Slower growers may offer more potential when the market deteriorates.
Everyone knows the good and the bad of getting into the emerging markets. "The tap is either all the way on or all the way off — all the time," said Andrew Foster, portfolio manager of the Seafarer Overseas Growth and Income Fund (SIGIX). He insulates against this risk by focusing on sustainable revenue — which often means slower growers — as opposed to companies with the highest immediate growth potential.
The fund's top five holdings include MSCI Emerging Markets Index heavyweights like Samsung Electronics and Infosys, but also shows how it separates itself from the index, starting at the top. A top five holding with a low rank in the MSCI EM Index is Bank Pekao SA (135th). The fund also has two top five holdings not in the MSCI EM Index: Hang Lung Properties and Singapore Telecommunications.
Bill Rocco, a senior analyst at Morningstar who covers the emerging markets, said growth at the expense of quality can be the by-product of a manager with too aggressive a stock-picking posture.
Foster looks for companies that can produce steadily growing revenue over the next five to seven years — sometimes longer — at a rate of about 7 percent to 15 percent. "That's the sweet spot," he said. And there are plenty of those stocks among the 800+ in the MSCI Emerging Markets Index, which had a median revenue growth of 8.12 percent for the last fiscal year, according to Morningstar data. The median price-to-earnings ratio in the MSCI EM Index is 15.12.
Seafarer year-to-date performance: (-7.49 percent)
Percentage rank in Morningstar category: 3 (among 857 funds)
MSCI Emerging Markets Index: (-19 percent)
A map of emerging markets fund returns
2. Avoid obviously 'crowded' trades, which in emerging markets can mean an entire country.
This should be obvious: Most of the focus in the emerging markets surrounded China in recent years. But not enough investors learned that obvious lesson until too late, said Zach Jonson, senior vice president of investment management at ICON Advisers. "That myopic view got a lot of people, I think, in trouble," Jonson said.
This fund's top five holdings include MSCI Emerging Markets Index heavyweights like Samsung and Tencent, but also two stocks with a low rank in the MSCI EM Index: ICICI Bank (165th) and Airports of Thailand (256th).
The ICON Emerging Markets Fund (ICARX), which is managed by Mick Kuehn, focuses on a number of other countries, specifically India and South Korea. "I think being overweight in those two countries, while being underweight in China, has really allowed us to avoid a lot of the carnage," Jonson said.
ICON year-to-date performance: (-5.72 percent)
Percentage rank in Morningstar category: 2 (of 857 funds)
MSCI Emerging Markets Index: (-19 percent)
The well-kept secrets of Brown Advisory
The best emerging markets manager this year — in fact, the only one among emerging markets mutual funds tracked by Morningstar to manage positive performance — is Brown Advisory Emerging Markets Small Cap Fund (BAFNX), up 3.38 percent through Sept. 28, versus an MSCI emerging markets small-cap benchmark down 11 percent. The company declined to comment on its performance — guess it doesn't want to give away any of its performance edge. But you can look at its top 5 holdings and learn a valuable lesson — slavish devotion to a big index like the MSCI isn't going to cut it, and if your manager is merely a closet indexer, their fund won't be worth the cost. Also, a move away from the large-cap names in the space has benefited Brown Advisory and JOHCM.
Take a look at the top five holdings in the Brown Advisory Emerging Markets Small Cap fund, according to Morningstar. Two of the five aren't even in the broad MSCI EM Index, and the three that are in the index are pretty far down the list, by weighting, among the 835 stocks represented in the index.
Top 5 holdings with low rank in MSCI EM Index: China Taiping Insurance Holdings Co (153rd); China Power International (394th); Hyundai Department Store Co Ltd (470th)
Top 5 holdings not in MSCI EM Index: Cuckoo Electronics; Korea Kolmar
3. Simple: Get stocks before they get expensive (which usually means smaller-cap names).
Stephen Lew, Emery Brewer and Ivo Kovachev, co-managers of J O Hambro Capital Management's JOHCM Emerging Markets Small Mid Cap Equity Fund (JOMIX), focus on buying stocks that are not largely covered by analysts.
"These companies are usually, if you find them early, rather inexpensive," Brewer said.
This fund's top five holdings include two stocks with a very low rank in the MSCI EM Index: China Everbright Ltd (415th) and Hanmi Pharm (495), and the three other top five holdings are not in the MSCI EM Index: Scb P-Note (Aisino), OCI Materials and Guotai Junan International Holdings.
Starting with small positions also helps to insulate against risk, Kovachev said. The fund begins to increase the weights in the portfolio as time goes on, and their confidence level in individual stocks strengthens.
JOHCM year-to-date performance: (-5.39 percent)
Percentage rank in Morningstar category: 1 (of 857 funds)
MSCI Emerging Markets Index: (-19 percent)
Although these strategies offer insight into investing in emerging markets — and investing in general — Rocco said it's important to remember that the same relatively conservative strategy that works well in a downtrend won't provide the same boost when the emerging markets go on an extended tear again.
—By Kate Drew, special to CNBC.com
