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Building a Better Portfolio With Emerging-Markets Funds

Industry experts discuss why closed-end funds are excellent vehicles to access emerging markets. 

Cara Esser, 05/08/2012

Last week, I moderated a panel of closed-end fund, or CEF, industry experts called Building a Better Portfolio: Closed-End Funds. (You can listen to a replay here and view the slides associated with the discussion.) The aim of the conversation was to highlight the importance of adding emerging-markets CEFs to create a well-diversified global portfolio. According to Morningstar's recent CEF readership survey, most investors hold CEFs following domestic-equity and fixed-income strategies in their portfolios, but a little more than a third of respondents said they used CEFs to access equity and fixed-income emerging-markets securities.

While much of the developed world struggles to stay afloat, many emerging-markets economies are thriving. A truly global portfolio no longer means holding investments in U.S. and European corporations or governments. As we've seen over the past few years, these economies (and many others) are decidedly linked. It's no longer good enough to diversify with developed nations alone. Emerging markets must play a role in an investor's portfolio. How big a role, however, is up for debate. 

Joining me on the panel were John Cole Scott, portfolio manager at CEF Advisors, Donald Amstad, head of fixed income at Aberdeen Investment Management, and Lewis Aaron, founder of Fund Consultants, LLC. After a brief introduction and overview of the dismal real gross domestic product growth that many developed nations logged last year and similarly bleak predictions for 2012, we jumped right in. 

An Overview of Global Equity CEFs
Scott began with an overview of his thoughts on emerging markets. He pointed out that more than a decade ago, 10% of the world's global equity weight was in emerging markets. Now, it is closer to 50%. He believes that, in order for investors to outpace inflation and meet investment goals, emerging markets should play a key role. But how should investors approach this market segment?

First, because CEFs sell at market prices that differ from their underlying net asset values, it's important to know what a "normal" trading range is for the group as a whole and also for the individual funds. Scott concludes that this range for non-U.S.-equity CEFs is generally between a 5% and 10% discount to NAV.

Next, investors should look at distribution rates. Non-U.S.-equity CEFs are not known as high income generators. These funds are better at growing assets and generally make most of their distributions by way of capital gains. The average total distribution rate for non-U.S.-equity CEFs, Scott's charts showed, is about 6% at market price.

Finally, Scott wants investors to understand that these funds can be volatile, and he uses average standard deviations to quantify this metric. While the funds have seen spikes in short-term volatility, longer-term volatility is fairly stable. In fact, pre-2008, Scott showed that average standard deviations were about 30% and, in the summer of 2011, the average standard deviation fell to less than 20%. It now sits just above 25%. He believes that fixed capitalization and active management of CEFs help to mitigate some of the inherent volatility. 

The Case for Asian Fixed Income
Amstad made his case for investors to add more emerging markets to their portfolios and said that Asia in particular should be a separate allocation. Overall, Amstad says that governments in Asia are more solvent than the United States, Japan, and the United Kingdom. These countries sport debt/GDP ratios that are nearing or above 100%, while China has a ratio well under 50%. But it does not end there. Amstad believes investors should be more concerned with a liabilities/GDP ratio, which for the U.S. has been estimated to be nearly 700%. The main reasons for this discrepancy are underfunded social safety nets in the West, which do not exist in the East. Amstad illustrated this with a personal story.

Cara Esser is a closed-end fund analyst at Morningstar.

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