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Emerging Markets: What to Know Before You Go

Jeremy Glaser
Patricia Oey

Note: This video is part of Morningstar's May 2015 International Investing Week special report.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It's International Investing Week. Today, we're looking at emerging markets. I'm here with Patty Oey--she is a senior analyst at Morningstar. We'll look at some of the recent performance of emerging markets and also some of her favorite funds.

Patty, thanks for joining me.

Patricia Oey: Thank you.

Glaser: Let's start with performance. We've seen kind of a bounceback in emerging markets recently. What's really driving that performance?

Oey: So, the MSCI Index is up about 10%, year to date, and it looks like maybe things are starting to pick up in emerging markets. But it's important to look beneath the numbers. What we're seeing is that the main drivers of performance have been China and Russia and, actually, it really hasn't been fundamentals that have been driving those markets. The other markets have been pretty tepid--low single digits.

Glaser: Let's start with Russia. Why did that gain so much?

Oey: Russia has had a big rally this year. Last year, the markets got pummeled, the ruble got pummeled. This is because of sanctions, followed by a tumble in the oil prices. By year-end, Russian stocks were trading at about 4 times P/E. So, [the Russian market] definitely oversold, and what we've seen is just a big bounce from that oversold situation in Russia.

Glaser: How about that China performance? The economy hasn't been doing so well, so why are stocks moving up so much?

Oey: Right. It's a good illustration of how people like to correlate strong GDP performance with strong stock market performance. And in China, we're always seeing news that GDP is slowing, but yet the markets have been on a super tear. What's interesting is that China is trying to reform its economy; there are many different things going on. They are definitely trying to open up their capital markets. One of the things they did is they are trying to improve liquidity in their capital markets, so they loosened margin-trading requirements. So, we've seen a whole flood of retail investors in China open up a lot of accounts, trade on margin. So, things are pretty frothy there. Any time the Chinese government might try to tap the brakes, we could see a lot of volatility.

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Glaser: If we see those two special situations pushing performance, when you look at your outlook, then, what should people reasonably expect to happen for the whole category?

Oey: One of the big themes in emerging markets is reform. Leading up to the 2008 financial crisis, everything was just super rosy--everything was growing really, really fast. And then since the financial crisis--it's been about eight years--it has taken a long time for these countries to focus and say, "What do we need to do to move into our next leg of growth?" So, that's reforms.

We've seen a lot of optimism about the reforms in Mexico, India, and Indonesia. Those countries are moving in the right direction. Reform is going to be slow. It's impossible to do things really quickly, so reforms will trickle through. Hopefully, companies will get better and we'll see good stock market performance.

Even in a place like Brazil: Their leader was re-elected last year. She has pursued some less-orthodox economic policies, and it seems like she is kind of tilting more toward market-friendly reforms. So, that probably is starting to look a little better as well.

Glaser: If you're an investor and you're thinking about getting some exposure to emerging markets, what's the best way to do that? Should you be looking at a low-cost ETF? Or is active management what you want here.

Oey: So, ETFs are definitely very cheap. Most of them are tracking a FTSE or an MSCI index. One of the issues there is that China currently accounts for about a quarter of both of those indexes, and both of those index providers have said that they are thinking about adding Chinese onshore stocks to their indexes. So, we can see the China weighting go up to more than 30%, which is kind of a heavy concentration. There are so many things going on with China and it is pretty volatile, so having such a large exposure to China is probably not a good idea.

In terms of active managers, a lot of the big and popular funds are closed. Among the ones that are still open that we like are Harding Loevner (HLMEX) and Virtus (HIEMX). They are both Silver-rated. The portfolio managers for both of these funds are pretty benchmark-agnostic; they are very good stock-pickers. So, we like those funds.

Our one Gold-rated fund is American Funds New World (NEWFX). They take a different approach; they invest both in emerging markets and in the developed world--just generally trying to get exposure to growth in emerging markets. And that typically is a little bit of a less-volatile fund because they invest in developed markets.

In terms of ETFs, we like the EGShares Consumer Fund (ECON). Consumer companies in that fund tend to be high quality. A lot of companies in emerging markets, historically, that have had ties with the government are in energy or in the financial sector; consumer firms are usually ground-up, entrepreneurial companies that are a little bit more well run. We also like the iShares MSCI Emerging Markets Minimum Volatility fund (EEMV); that's also a decent option for emerging markets.

Glaser: So, if you do go the ETF route, make sure you know what kinds of exposures you are getting; it could be an area where active management makes sense.

Oey: Right.

Glaser: Patty, I certainly appreciate your update on emerging markets today.

Oey: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.