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It’s not too late to catch emerging markets’ updraft

A shopper in India buys Tide detergent in Chandigarh, Punjab. The country has a growing middle class.

Sanjit Das/Bloomberg

Emerging markets have been the hot investment this year and last. Through 2016 and into 2017, the MSCI Emerging Markets Index is up more than 24 per cent (as of July 31). These markets also seem to be gaining steam, increasing more than 25 per cent year to date.

Investors who steered clear of emerging markets fearing their notorious volatility may now be wondering whether it's too late to jump aboard. Yet portfolio managers in this space contend they still have more upside, arguing that investors can ill afford to not have exposure.

The reasons are many, but all point to this sector's growing importance. Already, emerging markets represent more than 80 per cent of the world's population and more than one-third of global GDP. They also account for about half of global GDP growth over the past two decades, says Christine Tan, chief investment officer with Excel Funds, a Toronto-based investment firm specializing in emerging markets.

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Yet many Canadians are likely underweight in emerging markets, she adds. "If we were to simply make our portfolios look like what the world market cap looks like, a significant rebalancing would need to occur."

Emerging markets make up 30 per cent of the world's stock market capitalization, according to World Bank data, while Canada accounts for about 3 per cent. A 2015 Vanguard study indicates Canadians are about 56 per cent overweight in Canadian equities.

Investors must also acknowledge that emerging markets will fuel global GDP growth in the future.

Excel's research predicts that emerging markets will make up about 37 per cent of global GDP by 2020 with a growth rate of more than 5 per cent a year compared with that of developed markets, at 1.9 per cent. It also estimates that, by 2050, emerging markets' share of global GDP will grow to 66 per cent.

Much of that will be spurred by a growing middle class, says Sammy Simnegar, portfolio manager for the Fidelity Emerging Markets Fund.

Consider China, the largest emerging market. "About 10 years ago, there were about 50 million households in China with disposable income of $10,000 or more." At the time, the United States had double that, he adds. "Today China has about 250 million households and the U.S. has about 120 million."

Other nations with burgeoning middle classes are South Korea, Indonesia and India.

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Emerging-market growth has come with a shift in the economies of these countries. Once more dependent on exporting to developed markets, emerging markets are now increasingly focused on domestic consumption, Mr. Simnegar says.

Ms. Tan points to China, whose economy today is focused on "technology, education, environmental protection and consumer goods" for the domestic market. Technology in particular is growing fast, with Alibaba – China's answer to Amazon – and Tencent, a mobile video-game developer, as the largest players.

In India, more than 200 million bank accounts have been opened for the poor. "That's important because the government can directly deposit subsidies to those who need it most," she says, adding that this accelerates domestic consumption.

Still, expansion has been bumpy because the sector is diverse. Stock markets in India, China (Hong Kong) and South Korea have been surging. Brazil, after a rough few years, is also now in the midst of recovery with its MSCI index up more than 14 per cent year to date (July 31). But Russia remains in negative territory year to date down more than 11 per cent (July 31).

Russia and Brazil are both oil producers, and when oil prices fall, energy exporters – Mexico, Venezuela, Brazil, Russia, Saudi Arabia and Colombia – tend to suffer, says Gerardo Zamorano, director of the investments group for emerging markets at Brandes Investment Partners. At the same time, "there's a strong benefit for about half of the emerging markets" that import oil, such as China and India.

This kind of top-down view has limited value in investing, however, making passive strategies less effective than in other markets, Mr. Zamorano argues.

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A study by Copley Fund Research found 70 per cent of active equity managers in emerging markets beat the benchmark over the five-year period (ending March 31), and about two-thirds outperformed over 10 years (net of fees). This is not the case in developed markets, where active management routinely underperforms, he adds.

Mr. Zamorano further argues that a bottom-up approach – evaluating individual companies' value – is ever more necessary as valuations rise.

Emerging markets are becoming pricey, he says. "But on a relative basis compared to developed markets and in particular the U.S., emerging markets still look like an opportunity."

Adding to the upside is that emerging markets are recovering from a downturn that began in 2014. "When you look at emerging markets relative to developed markets over three– and five-year periods, it doesn't look all that good," Mr. Zamorano says.

So the bull likely has more to room to run, Mr. Simnegar says. That said, the long view is required – and expect volatility.

"For the first time in about a decade we have a globally synchronized outlook for growth, and that's positive for emerging markets, but don't try to time the market, chasing rallies," he says. "Instead, allocate funds on a regular basis to emerging markets to get exposure."

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