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Our upside-down world where emerging markets reign supreme

David C Stevenson has been cautiously bullish on emerging markets since the end of last year. Now it seems that more mainstream investors are coming around too. Here, he picks the best funds to buy.

Is it time to dive back into emerging markets? I've been cautiously bullish on them since the end of last year. Now it seems that more mainstream investors are coming around too.

Last time, I highlighted Terry Smith's new Fundsmith Emerging Equities Trust (LSE: FEET), which invests in high-quality, emerging-market, consumer-orientated stocks.I think it's a good trust, which sits alongside established offerings from the likes of Aberdeen and First State. But I worry that the high-quality' stocks these funds are chasing aren't exactly cheap. So I'd also look at ways to invest in specific regions and sectors, that you can use alongside these more mainstream options.

Tough times

But first, let's look at why emerging markets have performed so badly in recent years. In the last three years, most developed markets have shot ahead by 25% to 50%, yet emerging markets have actually fallen in value. It's not as if the big drivers of emerging-market growth have gone away population growth is still strong, and the pace of modernisation and urbanisation has actually accelerated.

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The trouble is, investors have been rattled by the increasing cost' of all this growth, and soaring debt in particular. For example, pensions consultant Redington cites data from credit-ratings agency Standard and Poor's (S&P) that suggests that, by the end of last year, outstanding corporate debt in China estimated at $14.2trn had overtaken US corporate debt, at $13.1trn. "S&P further estimates that China's new debt and refinancing needs are expected to reach $20.4trn in 2018, while the US will likely need about $14trn."

The fear is that these high debt levels will become unmanageable as growth slows in some emerging economies. Brazil tops many investors' worry list. S&P recently cut Brazil's credit rating from BBB' to BBB minus' (although it also moved the outlook from negative to stable), due to deteriorating national finances and slowing growth.

The real dodgy debtors

But concerns about debt in general are vastly overstated. Emerging-market experts Ashmore believe that total emerging-market debt grew by just 3% in 2013 to a total of $14.5trn. Total developed-market debt hit $103trn. So while the average debt burden in emerging economies is just 39% of GDP, unchanged from 2012, the debt burden in developed ones grew by 5%, to 280% of GDP.

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These numbers echo a complaint made in a recent book by economist Jerome Booth, Emerging Markets in an Upside Down World: Challenging Perceptions in Asset Allocation and Investment. Booth argues that many emerging markets nowoffer safer investment opportunities than many developed countries. Investors fret all the time about credit risk in the developing world but Booth reckonsthe real risk is in "heavily indebted developed countries".

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Yet debt isn't the only issue. Investors in emerging markets should pay particular attention to the flow and speed of money and capital flows globally. Research group CrossBorder Capital analyses these flows, with the goal of spotting key trends in global liquidity. The company looks at everything from credit creation to central-bank policies.

So far, these measures have been very accurate at predicting what happens next in emerging stockmarkets. Until recently, the global picture was very depressing from that point of view capital was flowing out of key emerging nations even as local firms were borrowing less, and China's government cracked down on credit creation.

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But the negative trend may be ending. In June, CrossBorder's measure of global liquidity showed signs of finally "bottoming out" as central banks become more accommodating. Not all of the research group's concerns have gone away. But we may be past the worst.

Markets may now respond to this cautious optimism. Hedge funds are already putting money back to workin local emerging-market equities.Bond prices may also receive a boost. I'd watch emerging-market bond funds (mainly exchange-traded funds) carefully they represent decent value in a world of expensive bonds.

This increase in money flowing into emerging markets may also be a sign that their economies are improving. Analysts at both Deutsche Bank and Credit Suisse expect emerging economies' growth to accelerate by 1% in the next 12 months to about 5.4%-5.5% next year.

Beware any sell-off

Now, before we get carried away, don't let this big picture' analysis blind you to the distinct possibility of another sell-off in emerging markets. Geopolitical risk is rising. Who knows what could happen next in the South China Sea, Ukraine, or the Middle East? But I expect each successive sell-off to get shorter and shallower, as the number of sellers steadily dwindles, largely because valuations are now so cheap.

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Given this cautious optimism, howshould you play any upside? You need to be very wary of how you approach such a diverse group of markets. Different countries and sectors will respond very differently to changing conditions.

That's one reason to go with experienced emerging-market stock-pickers, such as the managers at JP Morgan Asset Management, Templeton, Aberdeen (especially their Asian funds) and First State (also very Asia-focused) as well as the aforementioned Terry Smith FEET trust.

But for those who want to invest in more specific areas, I've looked at some of the best opportunities and how to play them below.

The best funds to buy into now

I'm still very bullish on frontier markets. Technically, these aren't part of the emerging-market universe, but they're usually lumped in with their bigger, wealthier peers.

I'm very optimistic on Africa in particular. Respected frontier-markets specialist Advance Emerging Capital which runs two established investment trusts in this area notes that frontier markets have had an excellent few years, especially compared with emerging markets. Advance's funds now hold more than $20bn of investors' money, from $10.8bn in 2013 and in 2014, Advance reckons much of this money will head for Kenya and Nigeria.

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The backdrop looks healthy for both nations. Nigeria is now Africa's largest economy, having recently overtaken South Africa after its GDP base was revised. Between now and 2020, the working populations of both Nigeria and Kenya are set to grow more rapidly than those of any other frontier market. And Kenya's middle class has the highest proportion of entrepreneurs of any frontier market, meaning it is fast-becoming a regional hub for both IT and energy companies.

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Advance Emerging Capital reckons that, even after recent gains, both Kenyan and Nigerian markets still look attractive. Nigeria trades on a forward price/earnings (p/e) ratio of around ten times, while earnings are expected to grow by 13.6% this year. Kenya trades on a forward p/e of 12, with 19% earnings growth forecast. As for how to play frontier markets, there are really only two funds worth following, both of which I've mentioned in the past. There's Advance's Frontier Markets Fund (LSE: AFMF), and BlackRock's Frontiers Investment Trust (LSE: BRFI). The BlackRock fund has a more impressive recent track record for its focused stockpicking, whereas Advance has been around for longer and uses local fund managers based in frontier markets.

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The other region I would focus on is Asia (excluding Japan and mainland China). There are some fantastic opportunities in this vast region, which covers everywhere from developed states, such as Malaysia and South Korea, to genuine frontier hot spots such as Vietnam, which I think represents great value. My two preferred ways to invest are the Schroders Asian Total Return investment trust (LSE: ATR) and the Halle Asian ProsperityFund run by Samarang Capital. Sadly, the latter is closed tonew investors, but the former is open for business and still trades at a decent discount to book value (around 5% at the timeof writing).

As for individual emerging countries, I'd highlight two in particular Mexico (see The best bets for investors in Latin America) and Turkey. Turkey's increasingly authoritarian leadership has attracted a barrage of bad publicity, but I believe this hides a much more positive economic story. Turkey is moving fast into the developed world, with a relatively strong economy although it has been too dependent in recent years on borrowing from foreigners.

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Mexico is also midway through a profound economic transformation as its reformist government takes on a number of sacred cows' including tackling local corruption, reforming the energy sector and improving local education. If you do choose to invest in either country, you'll probably be forced to use an ETF both nations' markets are tracked by ETFs from the likes of Deutsche db x-trackers. For example, you could use the db x-trackers MSCI Turkey ETF (LSE: XDTK) for Turkey and the db x-trackers MSCI Mexico ETF (LSE: XMES) for Mexico.

One last area to focus on is a theme-based approach: either an investment style cheap, value stocks that pay a dividend; or a particular sector utilities. There are a growing number of dividend-focused stocks within emerging markets my own favourite way to play this is through the Somerset Emerging Markets Dividend Growth Fund (Somersetcm.com).

In terms of sectors, my own favourite which I own in my self-invested personal pension is the Utilico Emerging Markets investment trust (LSE: UEM). This very specialist fund invests in emerging-market utilities and infrastructure assets and has a great track record it should also appeal to the more cautious investor looking for income-producing defensive assets.

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