Digital demand stokes big returns in emerging markets

At this time of peak uncertainty, pairing a global pandemic with a wildly unpredictable U.S. presidential election, one might assume a reduced appetite for investments in the far reaches of emerging markets.

But as most financial advisers will attest and many will swear by, investing is about diversification, and real diversification requires a certain level of risk and adventure.

Consider the knock-out performance of the $1.1 billion EMQQ Emerging Markets Internet & Ecommerce ETF (EMQQ), which is up 54% from the start of the year on the heels of a 34% gain last year. For context, consider the benchmark-tracking iShares MSCI Emerging Markets ETF (EEM), which is up 2.5% this year after gaining 18.2% last year.

The extreme disparity -- and EMQQ is not the only example -- is a reminder of where things are in the emerging markets these days and why financial advisers should tread gingerly into the space.

“This is a risk-on side of the market, and if the global economy recovers in 2021 the emerging markets could bounce back higher,” said Todd Rosenbluth, director of mutual fund and ETF research at CFRA.

The 26 countries represented in the MSCI emerging markets index includes a 41% weighting in China, a country that has demonstrated a relatively respectable 4% economic growth during much of the pandemic.

But while China and the so-called Northeast Asia cluster, including Taiwan and South Korea, get credit for containing the virus while not crippling their respective economies, the real strength of certain emerging market strategies concentrates on a trend the virus has propelled.

“Every consumer sector within the emerging markets is getting digitized,” said Kevin Carter, who launched the EMQQ ETF six years ago.

“The thing that’s emerging in the emerging markets is people,” he added. “They want stuff, and they want to move up, and I concluded that the broad market indexes were not the way to go for that kind of exposure.”

The EMQQ fund tracks an index of just 83 stocks, two-thirds of which are from China and 100% of which are pegged to Internet and e-commerce business.

“People in the emerging markets don’t have traditional bank accounts and debit cards and TVs with a thousand channels; they’re leapfrogging all that and going digital,” Carter said. “The traditional infrastructure that we think of doesn’t exist in the emerging markets. Kenya’s gross domestic product is 80% phone-based right now.”

In terms of concentrated emerging market bets, a similar story is found in the $3.3 billion KraneShares CSI China Internet ETF (KWEB), which is up 49% this year and gained 30% last year.

DIGITAL ACCELERATION

The flip side of this kind of bet on digital growth in the emerging markets is souped-up volatility in an already volatile category.

In 2018, for example, when the U.S. was engaged in a trade war with China, EMQQ lost 30% and KWEB dropped 34%, while the more diversified MSCI benchmark declined by 15%.

Of course, investors that enjoyed 2017 gains in the 70% range from the two concentrated strategies might have been able to better absorb the 2018 pullback. The MSCI index gained 37% in 2017.

Carter believes that, as with most of the world, the pandemic has accelerated digital trends that were already taking shape in the emerging markets, which is why he remains bullish even after such strong runups.

Meanwhile, when looking at the larger emerging markets landscape, not everyone is as enthusiastic at this point in the cycle.

“We’re slightly underweight emerging markets right now,” said Abdur Nimeri, head of institutional multi-asset programs at Northern Trust Asset Management.

“Outside of China, you will find the commodities and natural resources that drive those economies is pretty much impaired,” he said.

Nimeri is concerned with how COVID-19 is disrupting the supply chains in commodity-rich emerging economies.

“COVID adds a new layer of risk and the impact is much bigger in those emerging economies,” he said. “The risk case will be a lot more acute.”

TARGETED APPROACH

The expansive and eclectic nature of a category represented by more than 1,100 individual securities from 26 countries across five regions of the world is why some advisers prefer a targeted approach to the emerging markets.

“Emerging markets is a unique asset class and simply tracking a passive index can have drawbacks,” said Tony Matheson, wealth adviser at Matheson Financial Partners.

His client allocations to emerging markets can be as high as 10% for the most aggressive portfolios.

“I like the space, but it depends on what area of the space, which is why I prefer an active manager that can look under the hood,” he said. “I want to be more sector-focused to avoid areas like energy and banks because I’d rather have more of a forward focus on technology and pharmaceuticals.”

Paul Schatz, president of Heritage Capital, is also a believer in the benefits of the emerging markets.

“It’s a good diversifier and, while returns are volatile with large drawdowns, the long-term returns are strong,” he said. “Also, with so much emerging market debt denominated in U.S. dollars, if you get the dollar right, you can create a strong tailwind.”

The weakening dollar advantage is no small factor, according to David Semple, manager of the $2.4 billion VanEck Emerging Markets Fund (GBFAX).

“If we get an even bigger fiscal stimulus if the Democrats are in power, that would steepen the yield curve and further weaken the dollar, and if the Democrats go after big tech companies and stock buybacks that takes a lot of luster out of an expensive U.S. stock market,” he said. “For U.S.-based investors, the key is the dollar weakness we anticipate and if you layer a weaker dollar on a cheap asset class the returns to U.S. investors will stack up.”

Semple’s fund, which is up 5% this year after gaining nearly 30% last year, has not seen the kind of recent performance as some of the targeted ETFs, but he is focused on the Northeast Asian cluster.

“China, Taiwan, and Korea have done well containing the virus without shooting all their fiscal and monetary bullets,” he said. “The monetary stimulus by China has been much, much less than in the U.S. and Europe, which means they have room to ease further.”