Having been a neglected asset class for some time, emerging market stocks are enjoying a healthy rebound so far in 2016.
The story of how we got here is a familiar one.
When developing stock markets got overbought, they became overvalued. As a result, nervous investors – mainly from the United States – dumped those assets.
But the selloff led to a sharp 180-degree turn – emerging markets then traded at a 28% discount to developed countries.
Research Affiliates, founded by noted investor Rob Arnott, explains that emerging market stocks have only been cheaper than current levels six times.
Each of those periods sparked an average five-year return of 188%.
That should grab any investor’s attention.
So what’s the best way to invest in emerging stock markets?
Based on my decades of experience as both an advisor and an investor, I’ve compiled three quick tips to help you make sense of this market trend.
Tip #1: Do NOT Use Index Funds
I’m not a fan of index funds in general… but especially when it comes to emerging markets.
It’s a sure-fire way to be unsuccessful.
Why, you ask?
First, because indices severely restrict your investable universe. And they’re usually restricted to the most overbought and overvalued stocks.
Case in point: The Institute of International Finance points out that only $7.5 trillion out of a total of $24.7 trillion in emerging market equities are covered by indices from MSCI and JPMorgan.
The rest are simply ignored as if they don’t exist. Yet, it’s those ignored stocks that usually boast the best bargains and room for growth.
Tip #2: Avoid the Closet Index Trackers
Even if you do avoid index funds directly, there’s another problem: “Closet trackers.”
These are fund managers who like playing it safe. They couldn’t care less about outperforming the benchmark index for their shareholders.
These managers have at least 50% of their funds in index stocks, so their funds will mimic the underlying index. Needless to say, that’s not what you want.
Worryingly, a study from the World Bank revealed that 20% of equity funds were index trackers or closet trackers.
This is a complete waste of money from an investor’s viewpoint. You’re paying for active management, but you’re not getting it.
One example of a mutual fund company that usually goes off the beaten track and often invests in smaller companies is the Wasatch Funds (WGROX).
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Though I do not own their emerging market fund, I do own their frontier markets fund – Wasatch Frontier Emerging Small Countries Fund (WAFMX) – for exposure to the smaller frontier markets. Please note: The fund is closed to new investors if you try buying it through your brokerage, but if you go directly to the fund company, it’s still open.
Tip #3: Get Local Exposure
If you truly want exposure to developing markets, guess what? You’ll need to own shares in local companies.
And while it may seem like a clearer route to a profit, don’t do what many U.S. advisors espouse and have your sole exposure through multinational companies. Yes… there are many great multinationals with huge emerging market businesses – a company like Colgate Palmolive Co. (CL) comes to mind – they’re not the best way to gain exposure to developing markets’ economic growth.
I like to use this analogy when explaining this point to clients: Let’s say a Japanese investor wanted exposure to the U.S. economy. His broker recommends Toyota Motors Corp. (TM). After all, Toyota sells a lot of cars in the United States.
Toyota shares aren’t a good way to play the overall U.S. economy, as the stock only represents a very select fraction of market success. Neither is investing in emerging markets solely through multinationals.
Investing in emerging local companies is the best way to profit from more specific foreign trends.
There are all manner of resources available these days for researching foreign companies and stocks. It does take a bit of work, but the rewards can be well worth the time. Alternatively, you can leave the work to proven, active fund managers.
Regardless of which route you prefer, now is a good time to build positions in emerging markets.