A balanced portfolio is the safest route when dealing in emerging markets, according to Emirates NBD's chief investment officer.
BRICs can help investors build a wall of security
As investors pore over the alphabet soup that is the world economy, they should pick out the BRICs (Brazil, Russia, India and China), a few of the MENAs (Middle East and North Africa) and be very careful with the PLIGS (Portugal, Italy, Greece and Spain), not to mention the US.
That is the message from Gary Dugan, Emirates NBD's chief investment officer, who says the term "emerging markets" is increasingly becoming a misnomer.
"We truly believe emerging markets is where clients should have the bias in their portfolios. There is a huge opportunity here that investors have not yet grasped," Mr Dugan says.
This is not a solitary view, as many analysts are more bullish on the East than they are on the West, but Mr Dugan recently argued against the notion promoted by some that there is now too much money flowing to emerging markets and therefore the best opportunities are gone.
Yet before anyone rushes out to shift all their assets into emerging market stocks, it's worth digging deeper into his recommendations about how to play the sector, which are instructive about how to invest generally.
First, note that he suggests a "bias", which means he is only recommending investors go slightly overweight on emerging markets within a balanced portfolio. He is not recommending an "all-in" bet. If, for example, you are investing for the long-term and have 45 per cent in western markets and 35 per cent in emerging markets, with the rest in commodities and cash, you may want to shift to something like a 40:40 split or 50:30 in favour of emerging markets. You still achieve diversification but gain more if emerging markets outperform developed countries.
Next, Mr Dugan says not to overlook debt issued by emerging market countries. Many of these bonds are yielding double digits this year, while equities are close to flat. Within the chunk of money allocated to emerging markets, he advises an almost equal weighting between equities and bonds.
One reason Mr Dugan likes emerging markets so much is that he thinks the quantitative easing announced by the US this month - in which the Federal Reserve pledged to pump $600 billion (Dh2.2 trillion) into the flagging US economy - will lure pools of excess cash and further fuel economic growth.
But the Fed action will probably weaken the dollar, forcing many countries to adjust their own capital controls. Some will intervene to prop up their currencies, while others will be content to ride the market fluctuations. In the end, there will probably be vast differences between how emerging countries fare during the coming months.
Mr Dugan says it then makes sense to avoid an index fund, with blanket allocations across a number of countries, and instead look for an actively managed fund in which the manager is monitoring daily developments and shifting money accordingly.
"There will be some winners and some losers. So active management is better than passive management," Mr Dugan says.
For many investors, including this one, emerging markets are scary because of their potential for volatility. The inherent risk, of course, is what produces the opportunity for nice rewards, but the potential for some unforeseen event to send markets off a cliff is enough to keep someone awake at night. That's why Mr Dugan says: "You need a manager that can go both long and short."
What he means is that you don't want a fund that is just riding the wave of the market and you should look for one that instead offers "absolute return".
Most mutual fund managers gauge their success against a benchmark. They are not responsible for the economy, but they will maximise your returns given whatever the current market conditions are. The problem with this is that, as an investor, it is not much solace that you only lost 15 per cent when the broader market fell 20 per cent - you still lost 15 per cent of your money.
"Absolute return" funds promise to deliver moderate returns regardless of what happens to the larger market by using strategies historically employed only by hedge funds such as arbitrage, short selling and options. These types of funds came on the mutual fund scene in the past few years, but their performance has not lived up to the hype - like a toothpaste slapping "new and improved" on the box even though the consumer can't tell any difference.
To be fair, most of these funds do not have long track records, because they arrived on the scene en masse only last year, but it would be worth checking how an absolute return fund you are eyeing rode out the gyrations of the past two years. And if you are mostly aiming to even out the swings, check out a research site like Morningstar (www.morningstar.com), which ranks funds based on their volatility.
What about the UAE, you might be asking, since the FTSE this year elevated the country to a "secondary" emerging market? Mr Dugan says it remains a very shallow market, dominated by financial and property firms. Therefore, it should not occupy a large percentage of any portfolio, but overall it looks cheap. Based on a price-to-book value ratio, UAE stocks are selling at half price to the BRIC countries.
"You want to be in these markets if the price is right," he says. "We believe the price is very right."