Investors looking for equity exposure outside Canada may want to consider allocating part of their foreign holdings to emerging-markets funds. They invest in countries -- such as China, India and Mexico -- whose economies tend to be growing faster than the developed world. The category is widely diversified by region, encompassing Asia, Latin America, Africa and Eastern Europe.
In recent years, and for that matter over the past decade, investing in emerging-markets equities generally hasn't paid off. But developing countries with above-average growth rates, improving standards of living and a growing middle-class have the potential to produce above-average returns, as they have at times in the past, while providing greater geographic diversification for investors.
Morningstar's manager research team has given Silver ratings to two mutual funds in the Emerging Markets Equity category. These funds are highlighted below, as are two passively managed exchange-traded funds that are among the low-cost alternatives:
RBC Emerging Markets Equity
Expense ratio: 2.43%
Morningstar analyst rating: Silver
Philippe Langham, head of emerging-market equities at RBC Global Asset Management (UK) Ltd., favours companies that have growing cash flows and sustainable competitive advantages, and that trade at reasonable valuations. Langham and his team, who are based in London, also look for companies with good corporate governance and a strong management. The team creates a checklist to make sure stocks meets its investment criteria. The fund tries to keep sector and country bets within 10% of the benchmark, and the total portfolio is concentrated in just 50 to 60 stocks. On the other hand, the MSCI Emerging Markets Index -- the benchmark the fund tries to beat -- has well over 800 constituents.
The team prefers to look for companies that will benefit from increased domestic consumption. As a result, the fund is invested much more heavily in the consumer discretionary and staples sectors compared to the benchmark. It also may invest in companies that do business in emerging markets but are not based in one. At the same time, the fund has mostly stayed away from the energy and materials sectors, which are less likely to have consistent cash flow growth.
Given the team's focus on high-quality businesses, the Morningstar manager-research team believes this fund will outperform during turbulent times and provide a smoother ride than its peers in this volatile equity category.
Brandes Emerging Markets Value
Expense ratio: 2.71%
Morningstar analyst rating: Silver
Managed by San Diego-based Brandes Investment Partners L.P., this fund takes a deep-value investing approach and looks for stocks trading at least 15% below the team's estimate of their fair value. Sector analysts provide the research on potential investment opportunities, which are brought before a five-person investment committee for review. The committee members also make their own fair-value calculations, in order to improve the accuracy of the managers' fair-value estimates.
Each stock is rated and given a score of either low, medium or high. The position size for low-rated stocks is limited due to the additional risks. The ratings help improve the chance that the team's investment choices are cheap enough to limit the impact when riskier stocks decline.
The fund holds between 60 and 80 securities, and won't invest more than 5% of its assets in one particular stock. Management also limits industry and country weightings to the greater of 20% of assets or one and a half times the MSCI Emerging Markets Index weighting. The fund also has a 20% limit on stocks with a market capitalization of less than US$3 billion.
However, there aren't any minimum allocation requirements. As a result, the fund won't be forced to be exposed to overvalued sectors or regions. The fund is also allowed to invest in companies that aren't part of the index, including companies based in frontier markets such as Bulgaria or Vietnam.
Buying cheap stocks means the fund has considerable exposure to companies with weaker balance sheets. The managers have also allocated more of their assets to stocks domiciled in out-of-favour countries like Russia and Brazil.
"Management's strict valuation discipline often leads to heavy concentrations in markets where investor sentiment is weak," says Morningstar analyst Jeffrey Bunce. "Favouring the cheapest stocks means the team treads lightly in heated markets."
Vanguard FTSE Emerging Markets All Cap Index ETF (VEE)
Expense ratio: 0.24%
This ETF aims to track a broad index, the FTSE Emerging Markets All Cap China A Inclusion Index. The index is comprised of about 3,350 small, medium and large companies based in 22 different countries. It's among the largest Canadian-listed emerging-markets ETFs, and it's the cheapest, with a management-expense ratio of 0.24%.
BMO MSCI Emerging Markets ETF (ZEM)
Expense ratio: 0.29%
This ETF is designed to track the performance, after fees, of the MSCI Emerging Markets Index of large- and mid-cap stocks. The manager employs a sampling methodology when choosing investments, and doesn't hold all the companies that are constituents of the index. Along with direct holdings of stocks, the ETF may also invest in other ETFs. As of July 29, four of its top 10 holdings were other emerging-market ETFs, three of which are country-specific.
