Chapter Four
Getting Down to Business
How to Invest in Emerging Markets
Once you’ve decided you will move into emerging markets, the next question to decide for yourself is how to invest. The challenging world of emerging market investments holds great rewards, but also substantial risks for the investor. The criteria to be applied when evaluating the desirability of investments in those markets vary depending on your investment style and objectives.
As an investment manager, I believe in the efficacy of mutual fund investment and will outline why in this chapter. However, some investors may have a preference for purchasing stocks themselves, so I include a review of investment instruments and how to use them.
Primary investment instruments to access emerging markets may be summarized as follows:
- Emerging market mutual funds.
- Domestic listings of emerging market companies.
- Depositary certificate listings of emerging market companies in developed stock markets.
- Exchange-traded funds.
Let’s get started by looking at mutual fund investments.
Emerging market trusts and funds as we know them today began in 1986, with the launch of an emerging markets fund for institutional investors by Capital International and the International Finance Corporation (IFC). Individual retail investors were able to invest in emerging market funds in 1987, when Templeton launched its New York Stock Exchange—listed Templeton Emerging Markets Fund, Inc. At that time, no other U.S.-based mutual funds invested significant portions of their portfolios outside the United States. But today more than 27,000 mutual funds globally invest in international securities. And more than 6,000 of those invest exclusively in emerging markets.
Funds make the process of investing much more accessible, and require much less monitoring and research on a day-to-day basis.
Funds make the process of investing much more accessible, and require much less monitoring and research on a day-to-day basis. There are solid reasons for selecting funds as your instrument of investment: gaining exposure to potential high returns and reduced portfolio risk while shielding yourself from the complications of direct equity market purchases.
Closed-End Funds
A closed-end fund (in the United Kingdom they are called investment trusts) operates like any publicly listed company on a stock exchange. The fund raises capital by issuing a fixed number of shares via an initial public offering (IPO). These shares are then listed and traded freely on the market.
At the very early stages of emerging market development, closed-end country funds were a popular way of establishing emerging markets and putting them on the map among investors in the United States, Europe, and Japan. At that time, because of the low liquidity of emerging market stocks, it was felt that a closed-end structure would be best. In an open-end mutual fund structure, investors may redeem their investment from the fund manager at any time; in the closed-end structure, they are not able to ask for their investment back from the fund manager but must realize their investment by selling to other holders. In this way, the fund manager would not be challenged with a situation where many investors suddenly ask to redeem but the manager finds it difficult to sell the portfolio shares. Investment trusts or closed-end funds are sold just like common shares, with the transactions going through stockbrokers, where normal commissions are paid.
Of course, closed-end funds also provide investor a way to gain access and exposure to an emerging market without facing all the problems encountered when entering the markets themselves. In addition, since these country funds were closed-end funds and traded on the major stock exchanges, they were liquid, and investors could enter and exit the market rather simply.
There can be differences in emerging markets funds’ performance in view of the wide range of individual market behavior. One significant problem is that during certain periods of time, an emerging markets fund’s share price performance may not correspond with the actual value of the portfolio. Each day the net asset value (NAV) of the portfolio is calculated by dividing the total value of all the companies held in the portfolio, including cash and excluding any liabilities, by the number of outstanding fund shares. However, on the stock market where the closed-end fund is listed, the price of each fund share may not correspond to the NAV. Sometimes there may be a premium and sometimes a discount. The range of premiums or discounts can be wide. A discount indicates investor sentiment toward emerging markets is negative and/or they feel that the manager of the fund is not adding value to the fund. A premium, where the fund share price is higher than the NAV, indicates that investors are optimistic about emerging markets and/or believe the fund manager is doing a good job to enhance the NAV of the fund assets.
For buyers of closed-end funds, one of the greatest advantages is that they often sell at attractive discounts to their net asset values. In this way investors may purchase a basket of assets at a discount to their market value. Thus calculating the percentage difference between the share price and the net asset value per share is a key factor. Other factors to be studied are the percentage of total assets held in cash, the geographical spread of the investments, and the historical total return measured in terms of the performance of the NAV per share.
Open-End Funds
It is usually easiest to describe open-end funds as the opposite of closed-end funds. The differences between open-end and closed-end funds are numerous. However, the most important difference is the relationship between price and NAV. As we have said, the NAV of a fund is based on the sum total of all the market values of the fund’s securities positions in addition to cash, and less any liabilities. In the case of open-end funds or unit trusts (as they are called in the United Kingdom) the managers must be continuously ready to offer shares to incoming investors at the current NAV plus any sales charges and expenses. They also stand ready to redeem investor shares at NAV less any charges. In contrast, as discussed previously, in the case of closed-end funds, the holder must sell his shares in the market to obtain his money. The important element is that prices of open-end funds are the same as their NAV, whereas the share price of a closed-end fund is determined by the market and tends to differ from the NAV.
Both open-end and closed-end funds offer advantages, the most important of which are:
- Diversification.
- Professional fund management.
- Lower costs as compared to investing individually.
- Convenience in record keeping.
In open-end funds there is a tendency for flows into the fund to increase at the peak of bull markets and outflows to increase in bear markets. This could make it difficult for the fund manager to perform at his or her best. However, if investors cooperate with the fund manager and invest more money when the markets are down, then, in fact, open-end funds could be more advantageous than closed-end funds.
One advantage of closed-end funds or investment trusts is that investors can precisely control the price at which they purchase the shares. In open-end funds, the price at which the shares are purchased is not known until after the investor has made the commitment, since the NAV would be computed at the end of the trading day. Of course, in most cases the differences between the NAV from day to day are normally not great.
Domestic Listings of Emerging Market Companies
For the average investor with limited time, the most difficult method of investing in emerging markets is by directly investing in stocks listed on emerging stock markets. Such direct investments, because of unique local conditions or local investor sentiments, can result in spectacular returns or spectacular losses. When making such direct investments, there are numerous considerations such as foreign currency changes and their impact on the investment as well as the business in which you are investing.
Depositary Certificate Listings of Emerging Market Companies in Developed Stock Markets
For those who prefer to take advantage of foreign stocks without going to a foreign market or foreign currency, depositary receipts such as American depositary receipts (ADRs) and global depositary receipts (GDRs) are designed to give you just that chance.
Depositary receipts are receipts for shares of a foreign company deposited in that foreign country and traded on that foreign stock market. For example, American depositary receipts are traded in the United States. Normally American banks will have a custodial operation in the foreign country where the shares are traded. The shares are kept in the custodian’s vault in that foreign country, and then depositary receipts are issued against those shares.
Global depositary receipts are similar instruments, but they are traded in international exchanges, mainly in London and other European markets. They differ from American depositary receipts since they provide issuers with a means of tapping global capital markets by simultaneously issuing one security in multiple markets. Global depositary receipt issues often benefit from better-coordinated global offerings, a broadened shareholder base, and increased liquidity.
The advantage of depositary receipts is that they enable investors in the United States and Europe to invest in an emerging market company without leaving their home market. In some cases, the home market brokerage costs and other costs associated with purchasing and holding shares are even lower than in the emerging market. By not going into the emerging markets directly, the investor avoids considerable administrative and other complications. In addition, dividend collection and distribution are completed much more efficiently since the sponsoring bank undertakes to collect all dividends, and then distributes them to the depositary receipt holders after converting them into U.S. Dollars or the holder’s home market currency.
The disadvantages of depositary receipts are that they may sell at a higher price than the underlying stock in the home market, and they are sometimes less liquid than the underlying stocks.
Exchange-traded funds (ETFs) are much like closed-end funds in the sense that they are traded on a stock exchange much like stocks. An ETF has stocks in its portfolios and the manager attempts to hold the total value of assets close to its net asset value over the course of a trading date. Most ETFs have an objective of tracking an index. In the case of emerging market ETFs, they may want to track the MSCI Emerging Markets Index, the S&P/IFCI index, or others.
An ETF thus combines the valuation feature of a open-end fund with the trading feature of a closed-end fund. ETFs were launched in the United States in 1998 and in Europe in 1999 as index funds, but in 2008, the U.S. Securities and Exchange Commission authorized the creation of actively managed ETFs.
ETFs are sometimes attractive because they enable the investor to closely follow an index of stocks and, like closed-end funds, have stock-like features. In volatile markets, it is sometimes difficult for the ETF manager to exactly track a particular index if there is a great deal of volatility.
There is no guarantee that an ETF will always trade at exactly its NAV. If there happens to be strong investor demand, the ETF share price would rise above its NAV per share. This gives an opportunity for speculators to trade on the difference with the knowledge that the ETF manager will need to bring the NAV and price together again.
Managers of ETFs tend to use various arbitrage methods to ensure that the share price tracks the net asset value. Usually the price deviation between the daily closing price and the daily NAV is less than 2%, but sometimes the price deviations may be quite large.