The biggest driver of short-term returns in emerging markets

Emerging markets have had a great year so far. The MSCI Asia ex-Japan index is up 16% since the start of 2012, as is the wider MSCI Emerging Markets benchmark.

Western markets are mostly up by less than half as much. But of course, this comes off the back of an exceptionally poor year for emerging market stocks. Had you been in US equities throughout 2011, you're still some way ahead.

As usual, there are plenty of explanations for why this is happening. Stronger US growth will boost exports. China is set to loosen its property sector curbs. Greece will avoid default and get its next bail-out.

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But the reality is something a bit more tangible than that

Returns on emerging markets depend on foreign money

Emerging markets generally don't have a large domestic investor base. In particular, they don't have many institutions such as pension funds and insurers that tend to be steady buyers of stocks.

As a result, buying and selling by foreign investors has a major impact on the direction of most emerging markets. Flows in and out of the country drive a large proportion of short-term performance.

So far this year, emerging market equity funds have pulled in $19bn. That's about half the money that flowed out last year, according to funds tracker EPFR.

You see this a lot in emerging markets. In 2008, $39bn fled the region. In 2009, $64bn piled back in. Obviously, swings this size by foreign investors trump local sentiment.

Why are foreign investors buying back in now? It's not about the fundamentals. Very little has changed between late last year and early this year certainly not enough to justify a completely different assessment of the risks and rewards of emerging markets.

The truth is that people are investing again because markets are going up it's that simple. And markets are going up because they've attracted foreign money which in turn attracts more foreign money and so on, in a virtuous circle.

It's just crowd behaviour. And I am in no doubt that sooner or later it will reverse, and investors will blindly dump their holdings once again.

In due course, many emerging markets will build up their financial infrastructure. With a larger core of domestic buyers, this tendency to dance to the tune of foreign buyers will decrease. But in most cases, that's still a good way away.

Good asset allocation can deliver excellent returns

Dealing with this kind of volatility can be difficult which is why many investors lose money in emerging markets. They buy and sell in line with flows, ensuring they come in and out of the markets at the wrong times.

So what's the solution? One answer is almost to ignore it. Buy decent companies in good markets that you believe will outperform over time. As long as they do not become clearly overvalued, you ignore what happens month-to-month. In this way, you aim to pick up a premium for holding your nerve and being very patient.

This is the style of investing I prefer but I admit it's not exciting. The alternative is to try to design your strategy to capitalise on these moves. For most portfolios, your allocation between different assets is more important in determining your eventual returns than your choice of individual stocks and bonds. And the huge swings we see in emerging markets mean that if you get your asset allocation calls right, you can deliver some pretty good returns.

As an example, towards the end of last year, I went to a briefing from John Cleary, manager of the Generation Emerging Markets Fund. This is a multi-asset fund of funds built around strategic asset allocation between asset classes (equity, debt and cash) and individual countries across emerging markets.

The fund invests in actively-managed funds from firms such as JP Morgan, Fidelity or Ashmore. However, looking for exceptional manager outperformance in these isn't a major part of the strategy: the funds it uses are mostly of the 'index-plus' type, meaning that their mandate is to produce a return close to their market benchmark but ideally slightly over.

Most of the returns in the Generation fund are therefore driven by the asset allocation decisions. These are based on factors such as foreign flows, economic data, monetary policy and market volatility, as well as more qualitative criteria such as political issues in specific countries.

The fund's strategy has returned 85% since March 2007, against 14% for the MSCI Emerging Markets index over the same period. (The fund has only existed in its current form since the middle of 2011 the earlier track record is based on asset allocation recommendations from the manager to other funds.)

This was done with no leverage or shorting, so represents a fairly impressive level of outperformance from allocation decisions. For example, it avoided the worst of the 2008 market panic by shifting into cash early on, then moved into equities in early 2009.

Obviously, I have no idea if the fund will continue to perform so well - 2011 has not been such a good year for it. But it's a good illustration of how effective making the right short-term calls on asset allocation can be.

For any readers who are interested in researching the fund more, you can find details on the Generation Asset Management site. It's a UCITS fund with a minimum investment of US$10,000, a 1.5% management fee and 10% performance fee.