Emerging-market stock funds are looking less alike, which can mean big differences in returns

NEW YORK, N.Y. – When you’re built different, in investing, you act different. That’s why it’s important to check what’s in your emerging-market stock fund — even if it’s an index fund.

Emerging-markets index funds track different indexes, which can have very different exposure to different parts of the world. And as Brazil, India and other emerging market economies move in increasingly different directions, actively managed funds are looking more distinct as well.

Some managers are avoiding broad swaths of the developing world, and they say their funds have never looked this different from their index-fund rivals.

The big differences in composition can lead to big differences in returns. All of the 20 largest emerging-market stock mutual funds are down this year, but by anywhere from 3.9 per cent to 21 per cent, as of Wednesday. That gap of more than 17 percentage points is much wider than the 7.4 point gap in performance for the biggest funds in the largest category of U.S. stock funds.

The changes in portfolio focus are occurring as more dollars head into emerging-market stock mutual funds and exchange-traded funds. More than $5 billion flowed into them in the first 10 months of the year, according to Morningstar, at a time when nearly $73 billion left U.S. large-cap stock funds.

If you want to join the tide into emerging-market stock funds, it’s important to ask a few questions:

— If it’s an index fund, what index does it follow?

It may seem like a boring question, but it can make a difference, as a look at the two largest emerging-market stock ETFs shows.

The iShares MSCI Emerging Markets ETF keeps nearly a sixth of its portfolio in South Korean stocks, such as Samsung Electronics and Hyundai Motor. The only country that accounts for a bigger percentage of its portfolio is China.

Vanguard’s FTSE Emerging Markets ETF, meanwhile, doesn’t own a single Korean stock. That’s because the two ETFs track different indexes, which disagree on whether South Korea is an emerging market or a developed one.

Despite the difference, the two ETFs have performed similarly this year: Both lost 11 to 12 per cent, including dividends, as of Wednesday. But the ETFs are set to get even more different. The Vanguard ETF is in the process of adding small-cap emerging-market stocks to its portfolio, which are generally riskier than large-cap stocks but have the potential for bigger gains.

The Vanguard fund is also bringing in so-called A-shares of Chinese companies. These shares are listed in Shanghai or Shenzhen, and the Chinese government has only recently begun loosening limits on foreign ownership of them. A-shares have had much sharper jumps up and down than the Hong Kong-listed shares that many emerging-market stock funds focus on.

— If the fund is actively managed, what is it flocking to and avoiding?

Emerging-market stock indexes tend to be full of state-owned companies in China and commodity producers in Brazil and Russia. These are precisely the stocks that many active managers say they’re most keen to avoid.

China’s growth has slowed sharply, as the government tries to shift the economy away from industrial-led gains to one more dependent on consumer spending. That has helped send prices for metals and oil tumbling, which hurts Brazil and Russia. They’re big commodity producers, and both their economies are in the midst of recessions.

That’s why Laurence Taylor, portfolio specialist at T. Rowe Price, says adhering to an index is akin to “investing in the history of emerging markets.” He prefers countries that are smaller players in emerging-market stock indexes, but where growth prospects look better, such as Indonesia and the Philippines. He also favours India, which is well represented in emerging-market indexes.

Actively managed funds can also steer clear of places where politicians are making things difficult. When Russia, which makes up about 4 per cent of emerging-market stock indexes, annexed Crimea in 2014, it led to an international uproar and sanctions that hurt Russian companies badly.

Lee Rosenbaum, portfolio manager at the Loomis Sayles Global Equity and Income fund, which can invest anywhere around the world, sold the fund’s investment in the Russian Internet company after the upheaval. Now he says it’s safe to assume it won’t be buying another Russian stock again for a while.

— What are the fees?

As with investments in all funds, try to keep expenses low, regardless of whether you opt for a fund that tracks an index or is actively managed.

Investing in emerging markets can be expensive in general, and the average expense ratio is 1.56 per cent for mutual funds in the category. That means $15.60 of every $1,000 invested goes to cover fund manager salaries and other costs.

A fund manager with higher costs will need to perform that much better just to match the after-fee returns of lower-cost funds.