Investors who want to benefit from the recovery in emerging markets should use tracker funds, according to FE Alpha Manager Bill McQuaker, who has recently bought the iShares MSCI Emerging Markets UCITS ETF for his Henderson Multi Manager range. 
Owing to various headwinds such as slowing economic growth, political uncertainty and the impact of tighter monetary policy in the US, emerging markets have been distinctly out-of-favour with investors over recent years.
According to FE Analytics, the MSCI Emerging Markets index has underperformed the developed MSCI Word index over five years by 50 percentage points – and it’s a similar story over one and three years as well.
However, 2015 has been very different. Thanks to bombed out valuations, the prospect of looser monetary policy in China, the weaker oil price and other macroeconomic factors, emerging markets are outperforming their developed market peers year-to-date.
Performance of indices in 2015
Source: FE Analytics
A number of experts believe this trend will continue, such as Franklin Templeton’s Mark Mobius, due to the huge valuation gap between developing world equites and markets in the US and UK.
“I see this [the rally] continuing because if you look at the valuations of emerging markets now, it is lower than the US market and so there are a lot bargains for internationals investors to buy. That is the reason we are seeing the movement from the US to emerging markets,” Mobius told FE Trustnet earlier this month.
McQuaker, head of multi-asset at Henderson, is also bullish on emerging markets. However, instead of going down the traditional actively managed route for his exposure, he has bought the $4.9bn iShares MSCI Emerging Markets UCITS ETF instead.
One of the reasons behind his decision is because he wants instant liquidity to the market, but the key factor is because of the make-up of the index, trackers give the best geared exposure into the rally.
“We want plain, vanilla cyclical emerging markets exposure and a lot of companies that make up the index are lowly valued and low quality,” McQuaker (pictured) said.
“Although emerging markets have done badly, certain active managers have been able to perform well by focusing on quality. However, we want to buy areas which have been hurt badly over the last five years rather than areas that have performed the best.”
The iShares MSCI Emerging Markets UCITS ETF offers investors high levels of exposure to more cyclical areas of the markets such as financials, technology stocks and mining companies.
For example, our data shows it has three Chinese banks in its top 10 – China Construction Bank, Industrial & Commercial Bank of China and Bank of China – which is almost unheard of in the IA Global Emerging Markets sector.
Our data shows the iShares MSCI Emerging Markets UCITS ETF, which has a one FE Passive Fund Rating, has returned 109.92 per cent since its launch in November 2005 meaning its tracking difference relative to the MSCI Emerging Markets index has been 8.06 percentage points over that time.
Performance of fund versus index since Nov 2005
Source: FE Analytics
However, its tracking error has been low at 1.1 per cent. It has an ongoing charges figure (OCF) of 0.75 per cent.
One of FE’s best rated passive funds in the emerging markets space is the Vanguard Emerging Markets Stock Index fund. It also tracks the MSCI Emerging Markets index, but has had a tracking difference of 1 percentage point and tracking error of 0.25 per cent over five years.
Its OCF is also lower at 0.27 per cent – though it is an open-ended fund rather than an ETF, so it isn’t as easy to trade as the iShares vehicle.
While McQuaker likes the passive option rather than actively managed funds for his emerging market positioning due to the exposure it gives him, he has warned in the past that there is a genuine lack of quality in the IA Global Emerging Markets sector.
“I’ve got no question marks about the quality of the funds that we own, but I think, if you look at the fund offerings that are available to us in UK equities and in European equities, we’re blessed with plenty of good propositions to choose from,” McQuaker said.
He added: “When you move to emerging markets, it’s harder. There are not as many good offerings.”
FE Trustnet has written on a number of occasions about the poor performance of active funds in the IA Global Emerging Markets sector.
According to FE Analytics, the sector average has underperformed the index over one, three, five and 10 years while 72.6 per cent of funds are underperforming over one year, 69.2 per cent over three years, 72.1 per cent over five years and a staggering 84.6 per cent are underperforming over the last decade.
Source: FE Analytics
The average fund in the sector which has a long enough track record has only managed to beat the index in 3.8 out of the last 10 calendar years while the likes of Templeton Emerging Markets has outperformed in just one of the last 10 years and Scottish Widows Emerging Markets, which is still larger than £990m, has underperformed in each one of those years.
The sector’s stand-out performer has been the Aberdeen Emerging Markets Equity fund, which has beaten its benchmark in eight of the last 10 calendar years. However, the group has closed the fund due to strong inflows.
Mike Deverell, investment manager at Equilibrium, who is also a fan of using trackers for emerging markets, told FE Trustnet that there are a number of reasons why active funds in the sector have performed so poorly.
“One of the only ways that would explain it is costs,” Deverell said last year.
“If you look at the charges of emerging market funds, they do tend to be higher than UK-focused funds. That reflects the additional research that is needed and, like the facetious comment I made the other day, those charges will also probably go towards the fund manager’s flights.”
“However, not only have you got the higher costs from an ongoing charges point of view, there also the higher transaction costs. They have to pay bigger spreads and higher dealing costs than they would have to on the LSE.”
“If managers are being active and trading a lot, then it is going to cost them even more.”
