The best ways to play emerging markets

So we can't be blamed for thinking about more exotic climes. And it seems that's where the money is heading as well. Nearly 50% of institutional investors plan to increase their exposure to emerging markets in the next 12 months, according to a recent Deutsche Bank survey reported in the FT. That's the highest figure for any asset class.

We all know what happens when an asset class gets too popular. The bubble tends to burst.

But when? That's the catch

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Are emerging markets in a bubble?

Predictions of a bubble in emerging markets are nothing new. But investor enthusiasm, and the amount of money that's piled into them, are starting to make the argument look more convincing.

For example, emerging market exposure now accounts for a quarter of all the money invested in equity-based exchange-traded funds. That's well above the 14% weighting the region carries in the MSCI World Index, reports the FTfm supplement. And last month, the sector racked up record net fund sales of £336m, according to the Investment Management Association.

Yes, emerging economies are growing faster and are in better shape in many ways than developing ones. But strong economic growth does not always correlate to strong stock market growth in fact, figures from London Business School suggest that there has been zero correlation between the two over the past century.

Jeff Molitor of Vanguard suggests that the reason emerging markets have done so well over the past 10 years is a combination of two simple things. One, emerging markets were very cheap compared to developed ones a decade ago. And two, there has been a "growth surprise" in other words, investors have been nicely surprised by how well these economies have done.

When a cheap company beats market expectations, its share price tends to shoot up. Same goes for markets. But prices are now looking a lot more up-to-date with events. And they are no longer pricing in the sorts of risks that still go hand in hand with emerging markets, such as corruption, fragile property rights, and fraught political landscapes.

The trouble with bubbles

The big problem with bubbles, though, is that it's always hard to tell when they will pop. The bursting of the tech bubble was hugely damaging to investors caught up in it. But not participating in the bubble also put paid to quite a few City careers in the run up to the peak.

Private investors don't have to worry about performance reviews of course. But sitting on the sidelines while those around you are boasting of massive gains isn't a pleasant sensation. More to the point, just as with the internet, there is plenty of truth to the emerging markets story. These are rapidly growing countries with a lot of potential. It seems wrong not to have at least some exposure to them.

But how do you get exposure without being badly burned if and when things go wrong. There are a few options. Julian Pendock at Senhouse Capital often points out that you can buy emerging market exposure far more cheaply in Europe than in the domestic markets. Subsidiaries of many big multinationals are rated far more highly in emerging markets than they are over here.

So it's a case of buying Western companies with significant exposure to overseas markets. We're quite happy with that idea it covers many of the big solid blue chips we've been backing for a long time now.

Or you could buy markets that have been left behind in the rally somewhat. A few weeks ago in MoneyWeek magazine, Henry Maxey from Ruffer Capital gave his view on why developed markets might end up surprising us and beating emerging markets. He also gave us his favoured way to play it. You can read the piece here(if you'd like to become a subscriber click here for three free issues).

The best bets in the Asian markets

However, those with a bigger risk appetite could consider another option. That is to stick with emerging markets, but go off the beaten track. My colleague Cris Sholto Heaton regularly criticises the various index trackers and exchange-traded funds that offer exposure to emerging markets. Too often, he says, they are stuffed full of cyclical stocks such as resource plays or state-controlled companies. They rarely give investors the chance to invest in the genuine long-term growth themes, such as the rise of the emerging consumer.

So you need to do a bit of digging around to find individual stocks that look cheap and offer great growth prospects. That's not straightforward for your average retail investor. But that's where Cris comes in. His Asia Investor newsletter aims to find the best long-term stocks in emerging Asia. He's recently returned from a trip around the region with a load of fresh ideas.