The lure of emerging equity - step by step

Last Updated: Sat, Jan 12, 2013 18:41 hrs

Global investors seem happy to slip back into riskier waters of emerging market equities once again but it's a step-by-step process and ways of staying in the shallows are still being sought by many.

As reflationary policies of the world's central banks have sunk real yields on traditional safe-haven bonds into negative territory, income-seeking investors have over the past year or more pushed out to higher-yielding debt and 'quality' western blue chip stocks with hefty dividends.

And if, as some strategists now believe, the next big step is a 'great rotation' out of now expensive government and corporate bonds and into undervalued equity, then the big underperforming emerging markets, such as China, are back in vogue.

Describing this week as a 'decisive breakout' for equity funds at large, tracker EPFR said inflows to all equity mutual funds in the four days to Tuesday, at $6.8 billion, outstripped bond inflows. Cumulative inflows of more than $40 billion since the start of last month are now more than twice that to bonds.

Morgan Stanley's cut of the same data shows the full week to January 9 showed a record week of inflows to emerging market equities of some $7.4 billion, even as emerging bond flows stayed robust.

Markets have been responding. MSCI's emerging market equity index has jumped 6.5 per cent since the start of December, outstripping the five per cent gain on the global index . And Shanghai's gains of almost 15 per cent in that period show how much China's economic growth rebound has been a key driver and illustrates the fact that it emerged late last year, as most global investors top country pick for 2013.

Yet, with few believing the coast is fully clear given such a fragile global economy and financial system, persistent euro troubles and US budget wrangling, there's still demand for at least some safeguards and defensive strategies even in what are perceived to the riskier spaces.

One of the growing trends of 2012 was to start seeking emerging market stocks with big dividends, trying to find a middle ground between what have traditionally been considered white-knuckle rides of pure growth plays with the desire for steady income and lower volatility.

According to Lipper data there were at least 50 new funds launched worldwide last year specifically targeting emerging market income stocks -- or more than four times that amount if you include global equity or Asia Pacific equity income vehicles that include at least some proportion of emerging market names.

“What works for investors with this sort of product is that it's not totally beholden to the sorts volatility traditionally associated with emerging markets,” said Emily Whiting, portfolio manager at JPMorgan Asset Management whose emerging income fund launched in 2010 now has 250 million sterling in assets.

“The beauty is you reduce the risks, while benefitting from a compounding of the growth and income,” she said, adding that 250 emerging market stocks worldwide pay dividends of more than four per cent average available in Britain or European blue chip indices and the 2.5 per cent available on Wall Street's S&P500.

Dividend yields on emerging market indices at large are now at least equivalent of global benchmarks and dividend payout ratios as a percentage of earnings exceed US equities.

Julian Mayo, investment director at Charlemagne Capital who runs an emerging market income fund of more than 40 stocks, said the rolling 52-week volatility of this fund last year was 9.9 per cent, less than the MSCI emerging benchmark's 14.5 per cent or 19 per cent in Germany and 12.2 per cent in the United States.

"Essentially what we're aiming for is low volatility exposure to emerging markets," he said.

The fund - with stocks from across the emerging universe from Asia, Latin America, east Europe and the Middle East and with exposure to a range of sectors topped by financials, telecom and consumer stocks - returned more than 20 per cent last year.

China changes
For many fund managers looking at this area, the emerging market dividend story squares a number of circles for both investors and many developing countries alike.

For all their superior growth and balance sheet attractions compared with hobbled western economies and markets, emerging equities have continued to suffer volatile and dramatic reversals leaving the bigger BRIC (Brazil, Russia, India and China) markets underperforming persistently in recent years.

Western investor concerns about governance and transparency and fears of domestic capital flight have played their part.

But in many countries, especially China, the problem is at least partly a result of a lack of well-established domestic savings industry that seeks long-term income and returns from equities as opposed to the often short-term speculative activity of local retail and household players.

Mayo at Charlemagne said this is now changing and developments in China already this year could prove important in this regard and could be a "game changer".

This week the Shanghai Stock Exchange said listed firms will have to pay dividends of more than 30 per cent of annual profit or face stricter disclosure obligations, extending the authorities' push to lure investors back to the country's markets.

A sliding scale for tax on dividends came into effect from the start of the year.

So for all the focus this week and next on the ebbs and flows of high-frequency macro economic numbers from China, there is some hope of more stable footing for its markets over time.

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