The world’s first stock market index, the Dow Jones Transportation Average, was created in 1884 by Charles Dow. It consisted of just 11 companies. Dow didn’t know it at the time, but he had created what would later become the backbone of the global investment market.

Dow and other index pioneers set out to make the chaotic movements of Wall Street and the City of London understandable to the average person and today indexes dominate the investment world. Tens of trillions of dollars are benchmarked to key indexes and every quarter investment managers all over the world publish their results and judge themselves against the performance of these vital financial indicators.

As a result, the companies that calculate and administer the most important indexes have become gatekeepers of the global financial markets.

MSCI is one of three main index providers

There are three main index providers: S&P Dow Jones, FTSE Russell and MSCI. Each index has its own strengths and weaknesses and some are better known than others in key markets. For example, most UK investors are aware of the FTSE 100, managed and owned by FTSE Russell, which itself is owned by the owner of the London Stock Exchange, LSEG. S&P Dow Jones runs the two main US market indexes, the S&P 500 and Dow Jones Industrial Average. MSCI manages the world’s global stock benchmarks.

These companies provide benchmarking data to fund managers. When a company such as BlackRock (iShares) or Vanguard launches a fund, it signs a licensing agreement with the index provider. The index provider then tracks every dollar that flows into that fund to calculate the “licensing fee” they are owed, while providing up-to-date data on changes to the index. The fund managers could do this themselves, but using a third-party removes any conflicts of interest and allows investors to compare performance across different fund providers.

The flagship product of MSCI (NYSE: MSCI) is its MSCI World index, which covers the world’s 23 biggest and most important developed equity markets. The 1,320 constituents account for around 85% of global equity market capitalisation. The size and scale of this index means the company has become one of, if not the most important index provider in the world. According to its latest results, MSCI officially reported about $18.3trillion in total assets benchmarked to its equity indexes. Of that, $12trillion is in indexed (passive) products and $6.3trillion is in actively managed strategies. It also noted a record $2.2trillion specifically in ETFs linked to their indexes.

The scale of the company’s reach means that receiving its approval can be a make-or-break decision for companies and countries. Towards the end of January, shares on Indonesia’s Jakarta Composite index plunged 8% in a single day as MSCI warned that deteriorating liquidity could lead to the country’s removal from its leading developing-markets index.

MSCI is a profit engine

MSCI has four main business segments. Its index business is the flagship division. Revenue is generated through recurring subscriptions and asset-based fees tied to products, such as ETFs and open-ended unit trusts. It also has an analytics business that sells portfolio and risk-management tools. A sustainability division provides data and ratings to help investors address emerging environmental and social risks, which in turn has some overlap with the index division, as these ratings can help managers benchmark against environmental indexes. Finally, there’s the group’s private asset division, which provides performance data for private equity and real-estate managers.

Virtually all of the company’s revenue comes from subscriptions, either fixed-fee or asset-based subscriptions that asset managers essentially have to pay in order to maintain access to MSCI’s data and use its indexes as benchmarks. In many respects, this is a perfect business model. The industry is consolidated across three major players, revenue is recurring and the actual construction and maintenance of indexes has almost zero marginal cost.

In the fourth quarter of 2025, MSCI recorded subscription run-rate growth of 9.4% in its index business, with subscriptions growing 16% year-on-year in the custom index division. Analysts at UBS believe the overall growth rate could return to double digits in 2026, driven by rising demand for global passive trackers and the continued growth of private markets. Asset-based fees, mainly tied to ETFs, rose 21% year-on-year in the fourth quarter, while revenue from private markets rose 7%.

Management is also focused on reducing costs, leveraging AI to speed up processes while benefiting from economies of scale. UBS calculates the company’s Ebitda margin will expand by 170 basis points in fiscal 2026 to 62.5% and a further 60 basis points in the following year to 63.2%. These high margins reflect the fact that the business is a data company with substantial economies of scale, high switching costs for customers and long-term contracts. Indeed, last year the group extended its partnership with BlackRock until 2035.

UBS expects net income of $1.5billion for fiscal 2026, up from $1.3billion in 2025. As the global asset-management industry continues to expand, it could hit $2.4billion by 2030. Despite this growth, MSCI’s shares are trading at only 26 times estimated 2027 earnings, compared with its five-year average of 40 times. It’s also trading one standard deviation below its long-term valuation relative to the wider S&P 500. That seems cheap considering the firm’s global dominance.

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It’s a good rule of thumb to avoid new investment-trust issues until they have proven themselves. Still, there are always exceptions. In my experience, the most reliable trusts are launched in tough times. The Ashoka WhiteOak Emerging Markets Trust (LSE: AWEM) launched earlier this year, raising £31m, is a good example. 

Ashoka launched its Ashoka India Equity Investment Trust (LSE: AIE), managed by the same investment team, in July 2018 with just £46m. Since then, it has returned 131% against 74% for the MSCI India index, making it the best performer of the Indian trusts. Assets have grown to £263m. 

Prashant Khemka, the manager of both, spent 17 years at Goldman Sachs, where he built the India and emerging-markets funds, managing up to $5bn. He left to found WhiteOak in 2017 and based his team of 45 in India, giving them a competitive advantage. “India has high alpha [meaning there is a relatively large scope to gain returns in excess of the benchmark] and we have unparalleled expertise there,” he says. Khemka expects the 20% of AWEM invested in India to contribute nearly as much added value as the rest of the portfolio put together. 

Another area of high alpha is small and medium-sized companies. Khemka estimates there are 3,000 with market values over $500m available worldwide, including 600 to 800 in India – 1,000 if the cut-off is applied at $250m. “To maximise alpha, you cannot ignore small caps,” he says. Not because he believes that small and medium-sized companies outperform on average, but because they are poorly researched and more diverse. 

Companies, not countries 

Khemka does not seek “to choose countries that will outperform”, which is “impossible”, but “to identify companies that will beat the market in each country”. Just under a fifth of the portfolio is invested in developed-market companies that derive most of their value from emerging markets and enable governance issues to be overcome. 

Assessment of governance starts with a “net democracy score” for each country, provided by the Polity Project, a widely used database for monitoring governments. This scores Taiwan, Poland and India well but China, the Gulf and Saudi Arabia poorly. 

“Authoritarian countries have poor property rights,” he says. “How can you expect a government to respect the rights of foreign investors if they don’t respect the rights of small farmers?” 

That leads to underweighting China (21% of the portfolio compared with 30% in the allocation is compensated for with holdings in HSBC, LVMH, Naspers and Prosus, which has a large stake in Chinese internet giant Tencent. Exposure to Taiwan is 5% (underweight compared to the benchmark) although tech holdings include key semiconductor-equipment makers ASML and Disco. Khemka is also averse to the energy, mining, utilities and real-estate sectors owing to their exposure to unpredictable and arbitrary government interference. Companies majority-owned by the state have the same problem. Valuation is an “important consideration” in stock selection, although the portfolio has a higher return on equity and higher earnings growth, and is more expensive than the MSCI Emerging Markets index. 

Khemka is unapologetic about the 126 names in the portfolio: “Focus is counterproductive in emerging markets.” 

The top 15 holdings, led by Samsung and Taiwan Semiconductor, account for 35% of the total. Portfolio turnover is around 30% per annum and the overlap with the MSCI index is about 30%. All these factors, Khemka accepts, could cause the fund to underperform from time to time, but the likelihood is that AWEM will justify those brave enough to buy when most investors are hiding in foxholes. 

History and Khemka’s record are very much on investors’ side.

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This material is not intended as an offer or invitation to purchase or sell any investment.

There’s an incredibly strong argument that none of us knows or can control anything about the future of markets and economies. The only thing we do know and can control is that over-trading along with excessive fees are guaranteed to destroy our wealth. So in order to reduce the chances of fees and costs eroding our wealth we need to keep it simple and invest in broad funds such as global equity tracker funds. 

For some people, this form of simple portfolio management works a treat, but is it possible to earn better returns by being a bit smarter with passive fund selections, choosing different factor ETFs over traditional market trackers? 

Adding diversification

There is a significant school of research backed up by copious academic research which looks at how to break the global equity index into different factors. There are numerous factors out there, many tested to destruction and found wanting, but in my considered view only three remain standing – value and momentum plus small-cap stocks.

There are plenty of ETFs out there incorporating factors into global stock indexes. The ETF giant iShares is especially active in the space, with the iShares Edge MSCI World Momentum Factor ETF and iShares Edge MSCI World Value Factor ETF being some of the largest offerings. Other issuers are also getting in on the act. I would draw particular attention to VanEck with its Developed Markets Dividend Leaders ETF (TDGB) and Fidelity Global Quality Income ETF (FGQD).

The performance of these factor-focused ETFs has been mixed. Sticking with the funds offered by iShares, the momentum and value factor ETFs have returned 43.7% and 23.6% respectively over the past five years. That’s compared to the five-year return of 50% return for the basiciShares MSCI All Countries World Index ETF and 55.3% for the iShares Core MSCI World ETF (which tracks the performance of developed market indexes). Factor-focused ETFs are also more expensive with total expense ratios (TERs) of 0.30%, ten basis points higher than tracking ETFs. 

Not all about performance

I imagine most cynics will focus immediately on performance, but I would also argue that the last few years have been exceptional, with US mega-cap tech equities surging ahead due to the overall global reliance on cheap money and low-interest rates. 

Take Nvidia. In the momentum index, its weighting is 6.7%, as you’d expect from a stock with such strong relative outperformance. However, Nvidia doesn’t even make the top ten of the Value ETF (its biggest holding Cisco followed by Intel). Another bell weather stock is Microsoft which is 1.91% in the momentum index, 1.91% in the world index and 1.73% in the ACWI index. Again Microsoft doesn’t even feature in the top 10 of the Value index. 

Such large overweights will prove troublesome if the forces that have been driving the market higher over the past decade vanish. The different geographic weightings could also provide a level of protection against a change in the wind. 

Both the momentum and the value ETFs have appreciably lower exposure to US equities. The Value version of the index has a massive overweight to Japanese equities (seen as cheap by many investors).

I’m not making any grand statements or predictions on which ETF or combination of ETFs will suit you best, but it seems to me there’s a strong case for using these factor ETFs as an alternative way of building a diversified portfolio. The iShares ETFs and those of its rivals are cheap and you don’t need to pay much more for the focused screening provided. Who knows they might even provide you with a more diversified risk exposure to global equities. 

We’ve been telling you to buy Japanese stocks for the best part of two decades, although for the most part, this trade hasn’t worked out.

However, this year, Japanese equities are soaring. The Nikkei 225 Index has jumped an impressive 19.8% on a total return basis since the start of the year, taking the index to a 33-year high. In comparison, the MSCI AC World Index has returned 8.5%.

The weak yen is one factor behind the growth. As the Bank of Japan has continued to pursue a loose monetary policy in the face of global inflation, the yen has sold off against other currencies, improving the global price competitiveness of Japanese exports.

Japan is a major exporter of both vehicles and parts, electronics, and heavy machinery. A weak yen is also boosting Japanese companies’ overseas earnings when these are bought back into the country.

But there are other, more important factors at play here. These suggest there’s far more to the equity rally than just a cheap currency.

The bear case for Japanese stocks

Whenever Japanese equities have been recommended in the past, (and not just by us) bulls have always touted low valuations as a reason to buy.

Buying stocks when they are cheap or value investing has historically been a good way to grow your money. But this strategy does have its downsides. Cheap stocks can remain cheap forever unless there’s a catalyst. I’m not interested in buying a cheap company unless I know I can make money from it. If it’s going to remain cheap, I won’t make any money, so I won’t buy the stock.

And that’s the problem Japanese equities have had for around two decades. They’ve looked incredibly cheap, but there’s been no catalyst.

This seems to be changing. I’m aware I’m dangerously close to making another overly bullish prediction about Japanese equities. Still, I do see glimmers of a catalyst that could continue to drive equities higher.

Japanese equities have struggled over the past couple of decades because the economy has struggled. Inflation and economic growth have remained tepid. Even though the country exports a huge volume of goods and services, this has not translated into growth in the domestic economy.

If the economy is struggling, companies will struggle to grow earnings and investors will be reluctant to pay more for the same earnings stream as last year. Japanese businesses have also been averse to such shareholder value creation strategies, such as aggressive share repurchases, and large dividends.

In reality, tinkering with shareholder returns is only part of the equation. Without economic growth, the country’s equity market was always going to struggle.

The good news is wages are starting to pick up - great news for the economy.

The changing face of Japan’s labour market

Japan's labour unions have won overall pay gains of 3.67% in this spring's negotiations, a 30-year high for the country according to the Japanese Trade Union Confederation, the nation's largest labour organization.

By some estimates, this wage growth will boost consumer spending by 0.6% in nominal terms, and gross domestic product by 0.4%.

However, the headline figure of 3.67% masks more meaningful changes. The Nikkei Asia reports Japan's top retailer, Aeon, has hiked wages for its 400,000 employees by 7%. Meanwhile, those workers changing jobs have been able to pick up double-digit pay increases.

Higher wages are translating into inflation and GDP figures, and it looks as if this trend will continue.

Carl Vine, co-head of M&G’s Asia Pacific equity team has seen a noble increase in companies increasing prices for the first time in decades. Some manufacturers have not increased prices for 20 years, meaning their staff haven’t had a pay rise in this period either. Now staff are asking for pay rises and businesses are having to figure out what to do.

When I say they’re having to “figure out what to do” they really are. Vine has seen companies panic because they’ve never raised their prices. The “pricing mechanism at the company level is non-existent,” he says. It’s difficult to understand for most of us in the UK what this means. Some Japanese companies just don’t know how to raise prices and many workers haven’t had pay rises in decades.

They’re now making these changes. Attitudes are changing, “companies are saying I’m going to raise prices as I need to defend my margins,” notes Vine, suggesting a “radical overhaul in the way Japan is thinking about prices.”

Businesses are putting plans in place to change prices, and once these are in place, it’ll be easier to raise prices in future.

The bull case for Japanese stocks

There’s also huge scope for the country to improve productivity. Japan’s productivity per worker is amongst the lowest in the developed world. If it were the same as the US, GDP would be 40% explains Vine.

Here’s another growth string the country can pull. Higher wages may force companies to invest more in automation, enhancing productivity and GDP growth.

So, there are some very tangible signs it is different this time. Japan’s labour market seems to be waking up after decades of slumber, which is likely to drive GDP growth and higher corporate profits.

Of course, there’s always the risk this could be another false dawn for Japanese equities. So, investors might not want to commit too much of their portfolio just yet. But, considering the bleak outlook for the rest of the global economy this year, Japan is certainly looking to be one of the main growth stories of 2023.

MoneyWeek’s pick for exposure to the region is AVI Global Trust (LSE: AGT). It has a value remit and has a geographically diversified portfolio with 26% of assets invested in Japan, 35% in Europe (ex UK) and over 20% in North America implying this trust has some protection if Japan’s recovery turns out to be another false dawn.

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The recent news that the total value of the UK stockmarket had fallen $250bn behind that of France came as a shock. The UK now comprises just 3.8% of the MSCI All Countries World index, a share likely to fall as more firms emigrate or are taken over. BHP Billiton and CRH have gone already; Unilever and Shell were bullied by investors into staying, but could change their minds, and others are under pressure to follow.

Simon French of Panmure Gordon calculates that even after adjusting for the lower-quality composition of the UK market (itself a telling characteristic), UK stocks trade on an 18% discount to comparators overseas. Bidders are thus queuing up to snap up bargains.

Commentators assume that this is a recent phenomenon, readily reversible with help from the government. On the contrary: the crisis has been building for 25 years. The UK is like a Jenga tower from which, year after year, blocks have been removed, leaving it close to collapse.

A global powerhouse

In the 1980s and 1990s, the UK accounted for more than 10% of global indices. Pension funds and insurance companies were major investors in British shares, which accounted for half or more of their equity allocation. This was justified by the global nature of UK companies, which meant that underlying UK exposure was far lower. British companies were good dividend payers, and the tax treatment of payout was generous.

UK-listed companies financed most of the investment in North Sea oil and quickly embraced new technologies. The UK, as much as the US, was at the forefront of the 1990s boom in the technology, media and telecommunications (TMT) sectors. Privatisation resulted in the listing of around 40 large- and mid-cap companies; many more grasped the opportunity offered by the contracting out of services previously monopolised by government. The resulting improvement in efficiency was both profitable for investors and a key factor in Britain’s faster growth.

It all started to go wrong with the election of the Blair government in 1997. Labour had always hated privatisation and was determined to have its revenge. Unable to tax or confiscate investors’ profits, it imposed an arbitrary tax on privatised companies. These companies, seeing the public hostility the government had stirred up, rushed to recommend bids from overseas and private equity.

This reduced their accountability to their British customers, but nobody minded, preferring faceless overseas ownership to a UK-resident board of directors. Later, the government drove Railtrack and British Energy into bankruptcy by severely tilting the playing field against them. The result? Shrunken nuclear-generation capacity and the return to the operational and financial disaster that was British Rail.

In 1997, Labour abolished the tax credit on dividends, initially generating £5bn of additional tax revenue per annum. The Office for Budget Responsibility calculated in 2014 that the extra taxation had increased to nearly £10bn and taken a cumulative £118bn away from pension funds – around £230bn allowing for investment growth. The cumulative cost would now be a multiple of this.

As a result, defined-benefit pension schemes were closed to new members who were switched into defined-contribution schemes. These pension funds were encouraged to invest solely in government bonds instead of equities, which suited the public-sector borrowing requirement very well. Liability-driven investment (LDI) started as a sensible idea for a fully funded scheme to reduce risk, but ended as a desperate scramble for returns as bond yields fell to negligible levels. The increases in bond yields in the last year have irretrievably cost pension funds hundreds of billions.

Sending the wrong message

After the financial crisis, regulators tightened the screws on both pension funds and insurance companies, further reducing the supply of capital to equity markets. Private investors, through Isas, Sipps and investment platforms have taken their place but, sensibly, are much less inclined to favour the UK. Overseas investors got the message that the UK was becoming a hostile place to invest.

Unlike in the US, the technology and biotech sectors in the UK never recovered from the collapse of the TMT sectors. New companies are coming up through Aim and private equity, but the government focuses its attention on areas where we have little competitive advantage while knocking successful sectors. Levelling down, not levelling up, is the British way.

Britain had a huge competitive advantage in financial services, but regulatory crackdowns on banking and insurance, restrictions on banking bonuses and the additional corporation tax on banks have undermined that. Success in the North Sea has led to a windfall tax that absorbed over 99% of Harbour Energy’s profits last year. A windfall tax has also been imposed on renewable energy. It has been sufficient to bring new investment to a grinding halt.

The government is driving out the pharmaceutical sector through NHS pricing. Tourism has been hit by the abolition of VAT refunds on goods purchased in the UK – surely the stupidest policy enacted by Hunt and his Treasury Munchkins. As this implies, the change of government in 2010 only resulted in a ceasefire in governmental attacks on UK businesses, but hostilities have now resumed at an increased pace. The rate of corporation tax was reduced from 28% to 20% in the Coalition years, but it is now back to 25%. Even companies not directly targeted complain about the relentless rise of costly and burdensome regulation.

No wonder Bank of America’s monthly survey of global fund managers consistently shows the UK as the least favoured of developed markets despite its cheapness. This cheapness is the result of investors’ understandable aversion to the UK; that local investors are abandoning UK shares has not

gone unnoticed.

Low valuations have given overseas firms the chance to buy British businesses on the cheap. Kraft bought Cadbury in 2010 and SoftBank bought ARM in 2016 with institutional investors such as insurance firms and pension funds, only too happy to exit at a premium to the prevailing share price in their desperation to quit the equity market. Institutional investors are no longer controlling shareholders, but it’s unsurprising that retail funds with no net cash inflow accept bids when they can recycle the proceeds into other undervalued firms.

A long road to recovery

How can the relentless shrinkage of the UK market relative to the world be reversed? It will take multiple actions by the government, accepted and fostered across the political spectrum. Even then, it will take ten years before international investors, mindful of the UK’s terrible record, accept that attitudes have changed.

There does seem to be a move across the political spectrum to allow pension funds to invest in equities, but be under no illusion about the rationale for this.

Its purpose would not be to improve pension-fund returns or foster the revival of the UK stockmarket, but to provide funds for a financially hard-pressed government to invest in pet vanity projects with plenty of risk and no returns – HS3, perhaps. It would constitute another rip-off of pension funds.

It seems much more likely that the British equity market will continue to shrink as a percentage of the world total. This must surely threaten the contribution of financial services to the UK economy, which was estimated at £174bn, or 8.3% of total gross value added in 2021 (12.5% if related professional services are added on). Investors should beware the siren voices urging them to put their money into the UK, which is cheap for a very good reason. The outlook could change, but it is far too early to risk your savings on it.

Here’s an update on one of our long-term holdings in the MoneyWeek investment trust portfolio, Mid Wynd International Investment Trust (MWY).

The announcement that both Simon Edelsten and Alex Illingworth, managers of Mid Wynd, are leaving at the end of September is unwelcome news for investors.

They have managed the £480m investment trust since 2014 when they wrested it from Baillie Gifford. Since then the trust has returned 184%, significantly better than the 141% total return from the MSCI All Countries World Index.

Mid Wynd investment trust’s global edge

The managers have beaten the index by focusing on an investment strategy based around global investment themes such as “digital finance,” “healthcare costs” and the “low carbon world.” Overall, there are nine such themes, “materials” having been recently added, and around 60 holdings in the portfolio.

While Edelsten and Illingworth have always focused on a company’s long-term growth prospects rather than short-term trading, there is also a “disciplined approach to valuation” which enables them to pragmatically respond to changing opportunities.

This has enabled Mid Wynd to significantly outperform Scottish Mortgage (SMT) in the last year though it is still well behind over five years. It has outperformed Scottish Mortgage’s lower octane stablemate, Monks, over all periods, hence its inclusion alongside Scottish Mortgage in the MoneyWeek portfolio.

Edelsten and Illingworth are being replaced by Alex Stanic, who has just joined the managers, Artemis, from JP Morgan Asset Management, and two analysts who joined 18 months ago.

Presumably, Mid Wynd’s board is satisfied that there will be continuity of style and strategy but it is still not the smooth transition investors expect and Stanic will bring with him a different perspective on investment.

The managers are positioning Mid Wynd for the future

So why not sell now and look again in a year or so’s time when the performance since the change-over can be assessed?

The answer is that, far from coasting to retirement, Edelsten has made some portfolio changes that could pay off handsomely.

Following a meeting with the Chief Financial Officer of Exxon, Edelsten started to invest in energy.

“It was notable that he was able to spend time with us as fewer London managers wished to meet him on his London trip. This is something of a sign that most investors are looking the wrong way. He told us how investment has fallen short across the industry and will take ten years to catch up.”

Instead of Exxon, Edelsten bought into EQT, “one of the main gas producers in the Marcellus shale and a beneficiary of the political will to ensure gas is available in Western countries avoiding Russian pipelines.”

There is also a holding in Halliburton, a major oil services business, to benefit from increased capital expenditure. Both holdings are below 1.5%, but Edelsten has always preferred to build holdings steadily rather than rush into a position.

In addition, 13.5% of the portfolio is invested in Japan. “Mitsubishi UFJ trades at a 33% discount to book value,” he says, “while JP Morgan trades at a 40% premium. This is explained by MFUJ’s 6% return on book equity compared with JP Morgan’s 14% but this may be about to change.

Japan and China are benefiting from post-Covid re-opening and the Yen, having fallen from 115 to 150 to the dollar last year, is now recovering. This should lead to capital repatriation.”

“With inflation recently reaching 4%, the Bank of Japan can finally move away from the ultra-low interest rates that have been central to its deflation-busting strategy. This makes Japanese banks look particularly interesting; it would take only slightly higher interest rates for their profit margins to improve sharply,” says Edelsten.

There are also holdings in three automation companies and in Panasonic, a world-leading battery manufacturer.

Mid Wynd investment trust is worth holding

As to the broader market, Edelsten says “inflation is now retreating and, after a significant fall in the equity market, better value has started to appear. We have been impressed by how well our investments have coped with the challenges and have continued to grow their cash earnings. We remain confident that our portfolio is well positioned to grow in value in the years to come.”

There is enough promise in the portfolio and in the managers’ positive outlook to justify giving Mid Wynd the benefit of the doubt for at least another year. The shares trade at a discount of just 2% to the net asset value.

The Fundsmith Equity fund consistently ranks as one of the most popular equity funds among investors in the UK, and it’s easy to understand why.

Managed by star fund manager Terry Smith, since inception on the 1st of November 2010, the fund has produced an annualised return of 15.6% compared to 11.3% for the MSCI world index (in sterling).

However, 2022 was by far the worst calendar year of performance for the fund since its launch, both in absolute terms and relative to the global stock market.

It lost 13.8% last year compared to a loss of -7.8% of its benchmark. This year, the fund has performed marginally better, although it has still underperformed. In the six months to the end of June, Fundsmith returned 8.5% compared with 8.9% for the index.

Fundsmith's performance in 2023

Writing in his half-year letter to investors, Smith explained Fundsmith’s holdings in Waters Corp, Mettler-Toledo International, and cosmetics group Estee Lauder weighed on returns in the first half. 

“Waters and Mettler-Toledo have both been affected by the slowdown in laboratory expenditures post the pandemic. In neither case are we bothered by this. In fact, we hope it presents an opportunity for us to buy more,” the fund manager explained in the update. 

But he seemed more concerned about the performance of Estee Lauder. 

He said: “While domestic travel has returned, it seems that Chinese consumers are buying watches, handbags, and other luxury goods first which it was harder to shop for online during the lockdown. It has revealed some severe weakness in Estée Lauder’s supply chain with no manufacturing capability in Asia.”

This “debacle” could lead to Estee Lauder’s ejection from the portfolio, unless the company can turn the situation around. Smith doesn’t often sell holdings, but he’s been quick to eject companies from Fundsmith’s portfolio if they start to lose direction. 

For example, Smith recently dumped the fund’s position in Amazon, locking in a loss after first buying the stock in July 2021. In his half-year update, the fund manager explained that he’d made the decision to sell after the group’s new CEO, Andy Jassy seemingly decided to push the business in a different strategic direction. 

Smith said: “It is always easier to talk the talk than it is to walk the walk and the CEO’s pronouncement that he wanted Amazon to seek routes to get bigger in grocery retail ran counter to all these principles.”

“Where companies choose to invest outside a powerful core franchise in which they already have expertise we believe they are likely to destroy value, and especially so where they are entering a sector which already has poor returns,” he added. 

Buy and hold quality

Fundsmith has always been focused on buying and holding quality companies, a strategy explained by Fundsmith’s three-step investment strategy (1. Buy good companies; 2. Don’t overpay; and 3. Do nothing) is the best way to approach the market.

Fundsmith has even gone so far as to write an ‘Owner's manual’ to explain to its investors what it’s trying to achieve and how it will achieve it.

This whole process is designed to help investors focus on the fundamentals of the companies in the underlying portfolio, and ignore short-term market conditions.

One of the ways Smith does this is with a table in the Fundsmith annual report showing “what Fundsmith would be like if instead of being a fund it was a company and accounted for the stakes which it owns in the portfolio on a ‘look-through’ basis.”

On this basis, at the end of 2022, Fundsmith as a company had a return on capital employed - a measure of profit for every £1 invested in the business - of 32%, double the average of the FTSE 100 and nearly double the average of the S&P 500. It also had a gross profit margin of 64% compared to a mid-40s range for the indices.

These healthy margins have helped the companies in the portfolio absorb higher manufacturing and input costs that have hurt so many businesses over the past two years. 

As Smith explained in his note, “Procter & Gamble Co used to ‘make things’ for $0.50 and ‘sell them’ for $1.00, but now it costs $0.53 to make them. McCormick & Co Inc used to make things for $0.58 and sell them for $1.00, but now it makes them for $0.63. Estée Lauder used to make things for $0.20 and sell them for $1.00, now it costs $0.28 to make them.”

“This still leaves our companies’ gross margins way above those of the market average, which means their bottom lines are better protected, but they cannot completely offset these headwinds.”

But despite rising costs and squeezed margins, Smith isn’t changing strategy. 

The fund’s best-performing holdings in the first six months were Meta (up 140%), Microsoft (up 40%) and L’Oreal (up 30%). 

The author holds the Fundsmith Equity fund.

South Korea is planning to close the “Korea discount”, says Joori Roh for Reuters. Companies in Asia’s fourth-biggest economy have lower valuations than comparable businesses in other markets because of “low dividend payouts” and the “dominance of opaque conglomerates known as chaebols”.

Foreign investors have long complained about onerous administrative requirements to trade in Seoul and a lack of corporate information in English. South Korean firms also “confirm dividend amounts weeks after the so-called ex-date” (the day a stock starts trading without the value of its next dividend), making it difficult for income investors to calculate their returns.

South Korea is still classified as an emerging market by index provider MSCI. Indeed, its stocks account for 11.5% of the MSCI Emerging Markets index, much to the chagrin of the country’s politicians. In June MSCI again declined to upgrade Seoul to developed-market status, says Dave Sebastian in The Wall Street Journal. Poor accessibility for global investors and tight curbs on short-selling are hampering the market. Seoul has taken steps to liberalise its currency market, but it will need to do much more to secure an upgrade by MSCI. That could trigger $44bn in foreign inflows into local stocks, says Goldman Sachs.

Local assets could do with a lift. The Kospi stock index is down 20% this year, while the won is at a 13-year low against the US dollar. The won’s fall has been driven by a trade deficit that reached a record high in August, says Sam Kim on Bloomberg. Higher energy and commodity prices have swollen the import bill, while semiconductor shipments fell 7.8% last month. Car-makers also face new “headwinds” as Washington offers generous subsidies to US electric-vehicle firms.

Finding the best dividend stocks to beat inflation isn’t as easy as it sounds. But owning income shares with prices rising could be a sensible decision for investors.

According to research from Goldman Sachs, during periods of high inflation (greater than 5%), dividend stocks tend to do better than the wider market. The investment bank’s research is based on data for equities in the S&P 500 index going back to 1940.

A deeper look into the data only reinforces this conclusion. In the 1970s, a period of very high inflation in the US, the S&P 500 delivered total returns of 77% of which three-quarters was attributable to dividends and dividend reinvestment.

The data also shows that dividends can be an important component of total returns even in a low-inflation environment. Dividends and reinvested dividends have made up about half of the total returns of the MSCI AC World Index over the past two decades.

However, not all income stocks are created equal. Some companies are better positioned to deal with pricing pressure than others. Here are five dividend stocks that look best-placed to deal with rising inflation.

Dividend stocks to beat inflation

At the top of the list is FTSE 100 beverages giant Diageo (LSE: DGE).

Companies with the most pricing power are in the best position to pass on rising costs to consumers, and there are few corporations in the FTSE 100 with the same kind of pricing power as Diageo.

The company’s portfolio of brands, which includes premium and non-premium products such as Guinness, Smirnoff Vodka and Johnnie Walker whisky, means it has distribution across a number of price points and international markets.

With its substantial economies of scale and buying power, Diageo also has some of the best gross profit margins in the FTSE 100 providing a high level of protection against inflation to the firm’s bottom line. Companies with fatter margins are better positioned to absorb higher costs.

These qualities help Diageo stand out to me as being one of the best dividend stocks to beat inflation despite growing economic headwinds. The stock offers a 2.2% yield.

Rising commodity prices are driving inflation

Rising commodity prices are one of the main reasons why inflation has exploded over the past couple of months. One of the main beneficiaries of this boom is Glencore (LSE: GLEN). The miner and commodity trading house is virtually unrivalled in terms of size and scale in this market. It has access to information and pools of capital other companies can only dream of.

With its vast resources, it is able to take advantage of commodity pricing differentials in markets around the world. For example, if it can buy coal for $100 a tonne in one country and sell it in another for $105, Glencore will do just that.

With trading profits booming, Glencore thinks it will earn $3.2bn from its trading business this year, that’s at the high end of management’s expectations. And the longer these commodity market disruptions last, the longer the group will be able to earn abnormal profits.

Glencore has shown a willingness in the past to return excess profits to investors when it can, and that’s what analysts believe it will do this year.

Refinitiv analyst estimates have the stock yielding 8.9% this year and 8.5% in 2023. Additional cash returns could be on the cards in the form of buybacks as the company continues to earn bumper profits.

A dividend champion rising from the ashes

A company that might not be the first point of call for investors looking for income stocks to beat inflation is Phoenix (LSE: PHNX). This firm manages pension policies for over 13 million customers with just under £270bn of assets between them.

Phoenix has grown by acquiring books of closed pension policies, which other companies are trying to offload. By aggregating these assets, the group can streamline operations, reduce costs and earn a return on investment. It also branched out into the more conventional retirement savings market with the acquisition of Standard Life Aberdeen's insurance arm in 2018. Today, this is a key area of growth for the business.

Unlike other peers in the sector, such as Aviva (LSE: AV) and Legal & General (LSE: LGEN), Phoenix does not offer general insurance on cars or properties. Instead, it focuses exclusively on managing pensions and long-term savings products.

This focus on one product line (the group is also almost entirely based in the UK) might put some investors off from owning the stock. While I understand this viewpoint, I also think this business has some great qualities for an inflationary environment.

Phoenix does not manage the assets it holds to meet liabilities itself. It outsources this work (to keep costs low) and the managers have a mandate to invest these assets to deliver predictable returns. That’s very important when you’re talking about people’s life savings.

The company also hedges its business against inflation. In its latest results release the firm stated that the current inflationary pressures will have no material impact on its financial performance.

All of this means Phoenix has the hallmarks of a stable and predictable business, with stable and predictable cash flows. Indeed, management has calculated that the firm can generate £17bn of cash over the coming years. After stripping out expenses and other costs, the group reckons it will have £12bn of available cash to return to investors (excluding the impact of any acquisitions).

The stock currently yields 7.9%.

Defensive dividend stocks to beat inflation

A recurring revenue stream is a great advantage for any business, even more so if growth is built into that income stream. Long-term commercial rental contracts are a great example of repeat revenue streams and most commercial leases have clauses allowing for rents to be reviewed at regular intervals. This is very valuable in an inflationary environment.

Primary Health Properties (LSE: PHP) owns hundreds of medical facilities, mainly health centres and GP surgeries across the UK and Ireland. Five-year rent reviews are built into most of the company’s leases and the majority of its revenue comes from government agencies. I don't think you could find a more secure, inflation-proof income stream than that.

Structured as a real estate investment trust (Reit), Primary Health supports a dividend yield of 4.6%.

A defensive play with inflation-beating credentials

Utility Severn Trent (LSE: SVT) benefits from both an inflation-linked recurring income stream and a unique asset base that will only grow in value as prices rise, two qualities that make it stand out as one of the best dividend stocks to beat inflation.

Inflation will increase the value of the firm’s assets, such as pipes and treatment plants, which are costly and time consuming to replace.

What’s more, inflation will also reduce the value of the group’s debt in real terms. That should lead to an overall improvement in net gearing. Net gearing currently stands at around 60%, and 69% of this is fixed-rate borrowing.

The company is regulated by Ofwat, meaning it cannot raise prices as it sees fit, but the regulator is still allowing for growth. Severn Trent is offsetting higher costs elsewhere through cost-saving measures such as energy self‑generation, which now meets 50% of its needs.

These measures should allow the business to continue to grow its payout throughout the rest of the current regulatory period, which lasts until 2025. The stock offers a dividend yield of 3.6%.

Disclosure: Rupert Hargreaves owns shares in Diageo and Phoenix Group.

It has been a terrible six months for investment trusts. The FTSE All Share Closed End Investments index slumped by 18.9% compared with a fall of 4.6% for the FTSE All-Share index. Compared with global equities, the performance is better as the MSCI All Countries World index lost 11% in sterling. With the average discount to net asset value (NAV) in the sector widening to 9.8% from 1.5%, the underlying assets performed broadly in line with global equities.

After a stunning 2020, 2021 hadn’t been a great year, with the Closed End Investments index returning 12.8%, compared with 19.6% for the MSCI index. That was despite a fall in average discounts, but this year it seems that investors are losing faith in the investment-trust structure.

Value has eclipsed growth

Equity trusts had become increasingly focused on “growth” investing – partly the result of the outperformance of growth over value over many years, and partly due to the heavy focus of equity issuance on “growth” areas.

This explains why the UK market, with its high weighting in resources and value stocks, has outperformed this year. But although funds investing in the UK are still over-represented in the investment-trust sector, it has become increasingly global in recent decades.

While the MSCI ACWI Growth index lost 19.6% in the first half of 2022, the corresponding value index lost just 2.2%. Technology and technology-related companies, including biotech, had soared in previous years, but fell sharply, due to disappointing earnings, a revaluation of prospects, and contagion from the casualties.

This hit Baillie Gifford, the star fund management company of earlier years, hard. Its trusts accounted for six of the ten worst performers, including Schiehallion, its private-equity trust, down 52.7% and US Growth down 52%. Equity trusts are also heavily overweight in mid- and small-cap companies around the world and while these have a consistent record of outperformance in the long term, 2022 has been the exception to the rule.

Even in the UK, where the FTSE 100 lost just 3% in capital terms, the FTSE 250 index dropped 20%. Moreover, while the FTSE 100, along with other large-cap indices, appeared to have bottomed in mid-June, small and mid-cap indices continued to fall.

The healthcare sector has the image of being a “growth” sector, but trades at a discount to the market in the US, so it qualifies as “value”. It also performed poorly, although the focus of the investment trusts specialising in this area on biotechnology rather than the integrated major companies exacerbated their poor showing. However, there were signs of a sustained recovery by the end of the half.

Japan, once perennially expensive but now perennially cheap, also performed poorly, held back by the weakness of the yen. Emerging markets disappointed too, despite appearing cheap, but performance in recent years was an illusion. It had been propelled by the technology sector, particularly the Chinese giants, such as Alibaba and Tencent, but a clampdown by the Chinese authorities sent their shares tumbling. A tentative recovery now appears to be under way.

Good news on performance, valuations and disposals failed to sustain the private-equity sector, where discounts to NAV widened precipitously as NAVs rose and share prices fell. Investors believe either that the numbers are wrong, or that the fortunes of the sector are about to plunge, so they are following the herd rather than the experts. Even if the herd is right, reality is rarely as bad as feared.

Sentiment has also been hit by the unfolding disaster of Chrysalis Investments, regularly disparaged in MoneyWeek. Chrysalis lost 56.5%, making it the worst performer of all trusts. Remarkably, though, Literacy Capital, floated with little fanfare in mid-2021, returned 36%, making it the second-best performer in the investment-trust sector after Riverstone Energy, up 47%. Riverstone Energy, however, had been a disastrous performer in 2019 and 2020 so its share price remains at only half its peak.

Commodities come back to earth

The resources sector was the bright spot in the market, but its fortunes turned abruptly when commodity prices showed signs of peaking. BlackRock World Mining Trust’s share price rose 34% to a mid-April high, but then lost nearly all of its gains. At least the trust pays a generous dividend.

Also performing well was the “flexible investment” sector, including funds such as Ruffer, Capital Gearing, Personal Assets and RIT. They seek to protect investors in bear markets at the expense of underperformance in bull markets by investing in non-equity asset classes such as inflation-linked bonds, precious metals and infrastructure funds.

On average, these funds still lag global equities over three and five years, but RIT (despite poor performance in the first half), and Caledonia Investments are honourable exceptions, while Ruffer has been on a roll in the last three years. The other bright spot was the alternative-income sector, comprising property trusts (Reits), infrastructure, alternative energy and debt funds. This has been the growth area of the market and good performance almost across the board in the first half seemed to justify it.

The combination of generous, steadily rising dividend yields with moderate capital growth from businesses with low economic sensitivity and good inflation protection has proved attractive.

According to the Association of Investment Companies, in the last ten years equity trusts have fallen from 76% of the total (5% private equity) to 56% (12% private equity), with all the growth coming from alternative income and the flexible investment sectors. This trend continued in the first half, with nearly all the £2.4bn of new issuance, compared with £9.5bn for the whole of 2021, accounted for by these sectors.

There were no new issues in the first half, although this is more of a problem for the corporate brokers than for investors. There are gaps in the market – notably in conventional energy – but specialist managers have proved reluctant to float a trust, knowing that the best time to launch one was when energy prices were low and investors weren’t interested.

Closed-end funds remain popular

The AIC shows investment trust assets down from £280bn to £265bn, still the second highest on record, so their growing popularity over open-ended funds looks likely to endure. However, the rise in trust discounts, which has exacerbated poor performance, is a warning sign that patience is wearing thin.

The second half should bring better market conditions, but there could be more shocks and surprises over the summer. Sentiment is very negative, which is a positive indicator for markets as it implies that there is little room for deterioration.

But with economic growth slowing, developed markets facing – or already in – at least a mild recession and analysts reducing earnings forecasts, further patience may be required.

Inflation is probably peaking in the US and close to a peak in the UK and Europe, but how far and fast it falls back depends on energy prices. The oil price is back below $100 a barrel and future prices are at large discounts to current ones, but this trend could reverse.

Interest rates have further to rise, with the US Federal Reserve expected to raise US rates by 0.75% in July and as much again in September, but that should mark the peak. Government bond yields already appear to have peaked with the yield on the ten-year US Treasury back below 3%, having reached 3.4%, though ten-year gilt yields under 2.5% still look anomalously low. The good news is undoubtedly tentative, but markets never wait for certainty before they rally.

As historian Niall Ferguson says, “there’s a lot of doom and gloom in the air and the profession of being Dr Doom is a very popular one in the US – all you have to do is predict a financial disaster every year. There is very little mileage for the view that everything will be okay”.

We may not be facing “the Roaring Twenties”, but Ferguson points out that the 1920s “were not great anywhere outside the US” and represented an economic bubble that imploded in 1929.

“If the 2020s do end up resembling the 1970s,” he adds, “at least the 1970s were fun, when ‘we’re doomed’ was a comic tagline, not an obsession.”

If we’re not doomed, equity markets will rebound and investment trusts, helped by moderate borrowings, will outperform. Buyers will return in force and discounts could narrow as rapidly as they have widened, resulting in outsized returns. Whether that happens in the second half of 2022 or the first half of 2023 hardly matters. Unless you believe that markets are heading a lot lower, waiting risks missing out.

South Korea occupies an unusual place in global markets. It’s a wealthy, innovative economy that’s home to major international groups – such as Samsung, LG and Hyundai – that have strong positions in key industries. Yet the market is consistently cheap in nominal terms. The MSCI Korea index trades on 7.8 times forecast earnings, against 14.5 for the MSCI World.

There are several reasons why it’s on such a low valuation. Corporate governance remains an issue: family-controlled conglomerates (chaebol) dominate the economy and many have not always treated minority shareholders fairly. The stockmarket is still classed as emerging by MSCI – whose developed and emerging indices have a huge influence on how much gets invested where – due to trading restrictions. Many big firms operate in cyclical industries, and cyclical stocks trade at a discount to defensive stocks. And in the past, the presence of nuclear-armed North Korea just across the border stood out as another risk, but maybe in today’s world that’s a less idiosyncratic peril than it used to be.

However, governance is improving and promotion to developed status must eventually happen, so it seems plausible Korea will some day trade at a higher valuation. The Weiss Korea Opportunity Fund (Aim: WKOF) offers an unusual way to back that idea.

Buying at a discount

WKOF invests solely in Korean preference shares (prefs). These aren’t prefs in the standard UK sense of shares that pay a fixed dividend: in Korea, prefs are typically non-voting shares with a variable dividend that’s usually very slightly higher than the ordinary stock, but otherwise represent a standard equity interest. Prefs were typically issued around three decades ago when founding families wanted to raise more capital without giving up control. There are around 123 issues outstanding, says WKOF, ranging from Samsung Electronics to obscure firms that are best avoided.

Buying into non-voting shares may seem riskier, but in Korea a founding family typically holds enough of the voting rights to have control, so an investor in prefs isn’t at an obvious disadvantage to minority investors in common shares. In the past, investors in prefs have been treated equally to those in common shares, says Mark Lewand, head of investor relations at Weiss. Hence Korean prefs shouldn’t necessarily trade at big discounts to common stock.

Despite that, many do, which creates two opportunities. First, Korean blue chips already trade cheaper than comparable global peers. Through prefs, investors can buy in at a double discount, says Jack Hsiao, WKOF’s manager. Second, discounts change in response to corporate restructuring and better governance. A decade ago, Samsung Electronics’ prefs used to trade at a 40%-50% discount, but that has narrowed to around 10%. WKOF has rotated out of Samsung into other blue-chip prefs with wider discounts, such as Hyundai Motor, where such catalysts have yet to play out.

Respectable returns

WKOF has returned 123% in net asset value (NAV) terms since its inception in 2013, against 50% for the MSCI Korea. Dividends are paid annually, with a trailing yield of 3.5% on Monday’s close of 181p. The expense ratio is 1.8%, of which 1.5% is the management fee. A discount control mechanism keeps the discount fairly tight (2.2% on Monday). However, this is a small fund (assets of £127m) and the bid/offer spread can widen in these market conditions (now around 5%).

WKOF is a specialised single-country fund and not for every portfolio. Still, it looks cheap. The discount of its prefs portfolio relative to equivalent common shares is now 52%, as wide as it’s been since 2013, putting it on less than five times earnings. If you expect Korea to rerate upwards eventually, it should be one to hold and a good time to start buying.

After peaking at a multi-year high at the beginning of June, oil prices have tanked over the past couple of weeks.

The price of Brent crude oil has dropped more than 15% over the past month while WTI crude has slipped nearly 17%.

As oil prices have fallen, oil companies have fallen out of favour with investors. The MSCI Europe Energy 35/20 Capped Index, which is designed to provide investors with a benchmark of large and mid-sized European energy companies, has fallen by nearly 11% over the past month, although it remains up 21.9% year to date.

However, the performance of oil futures and oil stocks is becoming increasingly disconnected with the situation on the ground.

The supply and demand fundamentals of the oil market

Now that Russia has been ostracised from global oil markets, especially in the West, other producers are struggling to fill the gap.

Short-term disruptions such as lockdowns in China, the rising cost of living and the potential for an upcoming recession might push demand lower in the near term. But over the longer term, the prospects for the oil market still seem attractive.

According to projections from the Opec cartel of oil-producing nations, average oil demand is projected to rise by 2.7 million barrels per day next year to 103 million overall. Supply from non-Opec countries is expected to grow by 1.7 million barrels a day leaving the group to pick up the remainder. That could mean the region will have to raise output to as much as 33 million barrels per day.

Of course, these are only projections and I would caution against reading too much into the data. Opec has no idea how the economy will react to current pressures and there’s already some indication that high prices are having an impact on demand.

Still, the most important figures are production figures. The International Energy Agency (IEA) estimates that Opec can only produce 34 million barrels per day in the best case scenario, which includes output from Iran.

It’s not clear if this group of oil producers will even be able to meet this target as many nations are already under-producing compared to their existing output targets.

Then there’s the Russia wildcard. Russia produces around 10 million barrels per day. If its production drops by 10% or 20% it’s unclear if the world would be able to move quickly enough to replace that production.

Take all of these factors into account and while there is a risk that oil demand could drop and put further downward pressure on prices, I think it’s more likely prices will remain buoyant. As such, I reckon there’s an opportunity to buy shares in oil producers after recent declines.

Picking London’s best oil companies

I looked at London-listed oil and gas companies with a market capitalisation of more than £50m, and which have generated a positive free cash flow over the past 12 months. There are 17 of them.

The big oil companies, namely Shell (LSE: SHEL) and BP (LSE: BP) sit at the top of this list. These industry behemoths are by far my favourite ways to invest in the industry. Their diversification gives them a level of protection against oil price uncertainty and their size means they can achieve substantial economies of scale when dealing with suppliers.

Still, smaller producers offer more leverage to higher oil prices (although they do come with more risk). That’s why, if I was looking for a leveraged play on the price of oil, I would also own a basket of smaller production companies.

Excluding Shell and BP leaves 15 names. Of these I’m going to throw out Hurricane Energy (LSE: HUR) and EnQuest (LSE: ENQ) due to their weak balance sheets. Enwell Energy (LSE: ENW) is also out as most of its operations are based in Ukraine. Phoenix Global Resources (LSE: PGR) is out because it’s heavily loss-making (although it did generate a positive free cash flow last year).

Of the remaining names, Genel Energy (LSE: GENL) and Gulf Keystone (LSE: GKP) both focus on the Kurdistan region of Iraq. Meanwhile, Seplat Energy (LSE: SEPL) and Savannah Energy (LSE: SAVE) both have interests located in Nigeria and West Africa. Nigeria and Kurdistan both have a history of economic volatility and political uncertainty. As such, I’m not entirely comfortable investing alongside these companies.

That leaves seven names:

1. Serica Energy (LSE: SQZ)
2. Tullow Oil (LSE: TLW)
3. Harbour Energy (LSE: HBR)
4. Parkmead (LSE: PMG)
5. Jadestone Energy (LSE: JSE)
6. Diversified Energy (LSE: DEC)
7. I3 Energy (LSE: I3E)

Avoiding the companies that are struggling to create value

Diversified Energy has the highest dividend yield in the FTSE 250, at a staggering 13.4%, but there have been some questions about the company’s accounting practices and the cost of maintaining its production. As such, while I like the dividend, these operational corners put me off the business.

I’m avoiding Tullow for a similar reason. In recent years the company’s production has slumped due to operational errors. I’m not sure the business will be able to turn it around.

Parkmead’s market value sits at just £56m so it’s a tiddler in the market. Nevertheless, the firm’s portfolio of low-cost onshore gas assets in the Netherlands could help it generate revenues of £11.6m this year, according to Refinitiv analyst estimates, up from £3.6m. Net profit will hit £3.3m from a loss last year.

I3 Energy has assets in the UK and Canada, but it is spending heavily to maintain and grow production. While profits are expected to jump this year, high levels of spending could eat into shareholder returns in the long run. The company has already increased the number of shares in issue by 11 times in the past two years.

Jadestone has a much better record of shareholder value creation. After growing production by 10% last year, management is planning to boost output further by 36% this year from its US and Asian assets.

The group reported $180m of cash at the beginning of June, which is enough to fund its growth plans and return $100m to investors. Refinitiv analyst estimates have the company earning $114m this year putting the stock on a forward price/earnings ratio (p/e) of 4.5. The yield stands at 2.1%.

North Sea producers lead the pack with high profits

The last two companies, Serica and Harbour are both North Sea oil producers. While the government’s windfall tax will hit earnings, the fact that both are established businesses in a stable jurisdiction, with low production costs and strong balance sheets are all reasons to buy in my opinion.

It looks as if Serica is going to merge with Kistos (LSE: KIST). Both have made offers for each other in recent days, and I wouldn’t be surprised if one company wins out. Kistos only listed on the stockmarket last year and is half the size of its peer. Combined, the two would have production of 40,000 barrels per day and would be a force to be reckoned with in the North Sea.

Serica earned £28m in 2020 and that shot up to £415m last year. Analysts think the firm will earn £808m in 2022. Kistos (which will have to borrow heavily to buy its larger peer) has a portfolio of low-cost assets, and it is projected to see its earnings rocket from £64m last year to £441m this year. If I had to pick two producers for a portfolio, I’d buy both ahead of a deal.

Harbour Energy is the North Sea’s largest independent producer with production averaging 200,000 barrels per day. High oil prices are enabling management to put the business on a stable footing for the foreseeable future. It expects to be debt free by the end of 2023 even though it is ramping up capital spending. Harbour’s Tolmount gas field will increase the UK’s gas production by 5% when it comes onstream next year.

Along with Serica, Kistos, Jadestone and Parkmead, I’d buy Harbour Energy as part of a basket of London-listed explorers to capitalise on the tight oil market that’s expected to prevail for the foreseeable future.

At long last, the UK stockmarket is outperforming.

In the year to date (as of 25 May), it had returned 2.3% in sterling terms (though -5.1% in US dollars), more than 10% ahead of Japan, emerging markets and around 15% ahead of the US and Europe.

The MSCI All Countries World Index lost 17.8% in dollars.

Yet, according to Ed Yardeni, the UK stockmarket is valued at barely ten times earnings for the next year, compared with 17 for the US, 11 for emerging markets, and around 12 for Japan and Europe.

So, some argue (not least most of the rest of the team at MoneyWeek), the UK is not only attractively valued but the wind is behind it.

Should you stick with the UK?

The UK market has had a rough decade

The UK has outperformed all comers this year. But over the previous ten years, it was a different story.

MSCI’s UK index returned 65% (and barely 10% in terms of capital only – most of that was dividends) while the US market more than quadrupled. Japan and Europe each returned around 130% and only emerging markets performed as dismally as the UK.

Has the nightmare for loyal British investors come to an end? They have been globalising their portfolios for decades but most are still significantly “overweight” the UK (a phenomenon known as “home bias”).

The FTSE All Share index currently yields 3.3%, comfortably above other markets while the companies are more familiar than those listed overseas and prices are denominated in sterling, which means less currency “risk.”

That said, British investors have learned to be cynical about the long-term direction of the pound. The globalisation of businesses has also made overseas companies, particularly American, much more familiar.

However, a significant degree of home bias remains.

The classic explanation of the UK’s poor historic performance is that it is a “value” rather than a “growth” market. This however, fails to explain why relatively few growth companies have listed in the UK in the first place, or why so many established companies have failed to develop growth strategies.

To some extent, it is a value market because it has performed poorly, though a relatively high exposure to the resources sectors has certainly helped. But the sectoral composition of the UK market and its focus on value rather than growth companies does not explain all of the UK’s poor performance and valuation.

Nick Train, manager of Finsbury Growth & Income Trust, asks “are UK companies undervalued?” pointing to four growth companies in the UK that trade on far lower valuations than overseas comparators.

In fashion, Burberry is valued at 13 times earnings against 29 for Moncler; investment platform Hargreaves Lansdown is valued at 15 times against 22 for US peer Charles Schwab; fund manager Schroders is valued at 0.9% of assets under management against 1.9% for T. Rowe Price in the US; and business software group Sage at four times the ratio of enterprise value to revenues compared with ten for Intuit and 14.5 for Xerox.

Does the UK deserve to trade at a political discount?

There is an alternative explanation which is uncomfortable for Train and all UK investors; that UK shares are undervalued for a very good reason. Perhaps international investors regard the UK as an unattractive market because of a hostile media, public and political environment which means that lower valuations are required to compensate for the additional risk.

The latest example of this is the “windfall” tax on hydrocarbon production in the North Sea, which falls almost exclusively on UK-based companies since overseas companies sold out long ago.

This is at a time when the need for increased investment and production, now actively discouraged, has rarely been more clear. No wonder that ExxonMobil and Chevron appear “more expensive” than BP or Shell.

That the tax is not to be levied on generators of renewable energy is no comfort; this is said to be because such a tax would be too “complex” not because it would discourage investment. The required return on and hence cost of capital will rise as a result of the possibility being raised. Renewable funds will focus more on overseas investments.

This tax comes on top of the 4% increase in the rate of corporation tax to 25%. International investors know that the government party is supposed to be business friendly and that an opposition government will be much less so, especially now it has been set a bad example.

Those with long memories will remember a series of comparable raids; windfall taxes on banks and the ongoing higher corporation tax they pay, the levy on privatisation stocks in the late 1990s, and the stringent regulation of banks and insurance companies – supposedly EU-instigated, but still there – which has crippled their ability to bounce back from the financial crisis. In the last ten years, the share price of JP Morgan has quadrupled while Barclays is up 10% and Lloyds down 10%.

Who can rule out a “windfall” tax on the beneficiaries of higher inflation, such as food retailers? Or a tax on home delivery to “save the High Street”? No investor will believe that we have seen the last of “one-off” tax raids, anti-business regulation or government-imposed costs. The consequence is a reluctance to invest without correspondingly higher returns and hence slower economic growth. No wonder overseas investors are staying away.

The US is reassuringly expensive

The French government’s crippling of EDF to subsidise consumer energy bills shows that the UK has no monopoly on short-termism. But, in general, the EU and the euro act as a restraint on reckless governments. Change in Japan happens at a snail’s pace, which makes the business environment predictable. Canada does not want to drive business across the border and Australia is all too aware of the competition from Asia.

In the US, the Democratic party controls (just) both houses of Congress with a Democrat president, but the radical initiatives on tax, spending and government involvement in the economy have fizzled out.

The Democrats are highly likely to lose control of Congress in six months’ time and are very unlikely to control all three arms of government for another ten years.

In any case, competition between the states, the free flow of people and goods and the limits of federal involvement ensure overall stability. People may move from New York to Florida and from California to Texas, and they can choose to live in Washington state (10% sales tax, no state income tax) and shop in Oregon across the Columbia River (the other way around) but the US economy overall is unaffected and, in time, the states should come into alignment.

This makes the US market reassuringly expensive while the UK is cheap but riskier. Investors, like consumers, soon learn that it usually makes sense to pay up for quality, but the US is a quality market and the UK isn’t.

At the risk of contradicting the current views of my MoneyWeek colleagues, I’d argue that the UK’s current outperformance gives investors the opportunity to switch into global or overseas funds.

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Fund managers have always found it harder to outperform in the US than in any other market, which is why so many have chosen to invest via passive funds and exchange traded funds.

The US market accounts for well over half of the MSCI World index, but the intensity of competition makes it hard for anyone consistently to gain an edge. In addition, the largest companies have outperformed in recent years, yet fund managers nearly always tilt their portfolios away from the giants to allow them to invest more in companies that have only a tiny weight in the S&P 500.

An exception to the rule

Still, one fund stands out. Since Tim Parton and Jonathan Simon were appointed co-managers of the £1.5bn JPMorgan American Investment Trust (LSE: JAM) in 2019, they have outperformed the S&P 500 by 3% per year.

The duo manage a portfolio of just 40 stocks, with Parton running the half made up of underappreciated “growth” opportunities, and Simon the half made up of “value” stocks with a “durable franchise”.

Parton avoids stocks without established businesses or visible cash flow. Simon avoids those that are simply cheap. Value includes Bristol Myers and Abbvie in the healthcare sector and Berkshire Hathaway in the financials.

Growth is underweight in technology, but includes agricultural machinery company John Deere and Intuitive Surgical in healthcare. Both keep an eye on the benchmark so Apple is held at a below-benchmark weighting. There’s Mastercard, but not Visa; ConocoPhillips, but not ExxonMobil.

Tesla was recently bought back after being sold last year. JPMorgan Chase cannot be held, but there is a sizeable holding in Bank of America. The value is added in lesser-known companies such as Loews (hotels, insurance, energy and packaging), Weyerhaeuser (the largest listed timber company), Martin Marietta (building products) and Packaging Corporation of America.

Some 5% of the portfolio is invested in smaller companies by a separate team, though this has held performance back recently. The equivalent of 6.5% of net assets is borrowed to enhanced performance.

The overall portfolio valuation is similar to that of the S&P 500, and the average market value of the holding is only 10% less, at $552bn. This makes the solid performance achieved while carefully controlling the risk relative to the S&P500 all the more creditable.

The trust deserves to be a core holding in almost any portfolio, particularly since UK investors tend to be underexposed to the US market as a default consequence of a high exposure to the UK. Those who relaxed about their avoidance of the “expensive” US market when the UK index at last started to outperform earlier this year need to start worrying.

The UK’s relative recovery is starting to look like a flash in the pan due to the poor performance of its financial sector and the carpet-bagging stocks from emerging markets.

American alternatives

There are two other investment trusts focused on North America: Baillie Gifford US Growth (LSE: USA) and Pershing Square (LSE: PSH). Both have performed well in the last three years, but JAM gives the broadest exposure to the US market. US Growth has performed well when growth shares are in favour, but not when value is outperforming. Pershing Square is highly focused – it has just 11 holdings, of which two are below 1% of the portfolio – and often activist in its approach, seeking to bring about change in the companies in which it invests.

However, that is not the case with two recent investments in Universal Music (25% of the portfolio) and Netflix (11%), the theses for which look highly promising. With a three-year return of 124%, PSH’s 30% discount to net-asset-value compared with 3% for JAM can only be described as bizarre.

Stock indices are a crucial feature of the global financial landscape, says Sydney Maki on Bloomberg. They are “followed on autopilot by trillions of dollars in passive investments, and used as a benchmark for trillions more in active strategies”. More than $16trn globally is thought to be benchmarked to indexes compiled by MSCI, and inclusion in these is “an important symbol of acceptance in the mainstream global financial community”.

So the news that Russian stocks will be removed from MSCI’s main emerging markets index at a price that is effectively zero., in the firm’s own words, is highly significant: it shows how Russia has been “cut off from large swathes of the investing world”, says Maki. Sanctions, the closure of the Moscow stock exchange and a ban on foreigners selling assets locally mean that the market is essentially uninvestable, says the Financial Times. Other index providers, such as FTSE Russell and S&P Dow Jones, plus investment bank JPMorgan, which produces several key emerging-market bond benchmarks, are also removing Russian assets from their indices.

Unless investors have taken specific bets on Russia they are unlikely to notice big losses from the index writedowns. Russian stocks made up less than 4% of the MSCI Emerging Markets index at the start of the year, a sharp drop from 2008 – when it accounted for 10%. The Universities Superannuation Scheme, Britain’s biggest private pension plan, has just 0.5% or so of its portfolio in Russian-connected assets.

Still, as Hermitage Capital Management’s co-founder Bill Browder says, the sudden dash to sell near-worthless Russian securities is “a reminder that if you do business in countries without a rule of law, you could lose everything”.

“The calamity of Russia’s war in Ukraine has put an end to international financial investing in Russia,” Christopher Granville of TS Lombard tells Bloomberg. International investors owned an estimated $86bn in Russian equities as of the end of last year, but sanctions and a Russian ban on foreigners selling securities may leave billions of dollars trapped. Index compiler MSCI is now seeking feedback on whether to remove Russia from its stock and bond benchmarks.

The Moscow Exchange closed at the start of the week as regulators tried to head off a meltdown. The local Moex stock index is already down by more than a third this year. But while trading in Moscow was suspended, “many Russian companies are listed on overseas exchanges or trade there as depositary receipts”, says Evie Liu in Barron’s. “Those shares continued to trade on Monday, and it didn’t look pretty.”

Shares in London-listed steel business Evraz fell by 55% in five days. That is a heavy loss for “Roman Abramovich, who owns a 30% stake in the company”, says Susannah Streeter of Hargreaves Lansdown. Shares in gold miner Polymetal are down by 75% since the war began: its main buyers are Russian banks, which are being frozen out of the global financial system. Both firms look set to be relegated from the FTSE 100 at this week’s quarterly review.

Heading for default

Foreign bond investors may also get burned, says Matt Wirz in The Wall Street Journal. Russian government bonds fell more than 50% at the start of the week because of fears that sanctions could make it impossible to receive interest payments. “Russian 5.25% dollar-denominated bonds due in 2047 were quoted around 30 cents on the dollar.” This is a sign that investors think a default is very likely.

That could be financially contagious. “Banks in France and Italy each own about $25bn of Russian government bonds, and Austrian banks held roughly $17.5bn of exposure,” Ray Attrill of National Australia Bank tells the Financial Times. Thus a default would “echo through the European banking system”.

Overseas arms of Russian banks may collapse (such as Sberbank Europe), but “these are probably too small to create systemic risks”, says Neil Shearing of Capital Economics. Nonetheless, the possibility of a bank run in Russia remains a serious risk.

Still, “it is hard to conceive a complete collapse of Russia’s economy as long as it can keep selling its oil at almost $100 a barrel”, says Jon Sindreu in The Wall Street Journal. That will bring a $20bn current account surplus each month. And the plunging rouble (see below) will depress domestic consumption, which could drive that surplus even higher, towards $30bn a month, says Sofya Donets of Renaissance Capital.

Investors head for safe havens

“The idea that geopolitical uncertainty raises the gold price isn’t mere folklore,” says Chris Dillow in Investors’ Chronicle. “Since 2006, a one standard deviation rise in uncertainty has been associated on average with a $230 per oz rise in gold.” So it’s no surprise that gold has now topped $1,900 per oz for the first time in 18 months.

Other safe-havens are also drawing more interest. Bond yields – which move inversely to prices – had been rising this year on expectations of tighter monetary policy, but markets are now pricing in slower interest rate rises. Yields on the benchmark US ten-year bond have fallen back to mid-January levels. Yields on Germany’s ten-year bund have fallen back below zero. Safe-haven currencies have also risen. The Swiss franc has hit its strongest level against the euro since 2015, while the US dollar is at its strongest since June 2020.

Cryptocurrencies are also emerging as a surprising safe-haven, says Ipek Ozkardeskaya of Swissquote. Bitcoin had fallen back earlier this year, but it has gained more than 12% against the dollar since the start of February. “The coin… is now the asset that Russians and Ukrainians rely on” as their access to the traditional financial system is closed off, with strong reported purchases “using roubles and hryvnias”. But for Western investors, the idea that cryptocurrencies may be used to evade sanctions raises new regulatory risks.

One of the core components of the Moneyweek Investment Trust Portfolio is RIT Capital Partners (LSE: RCP). We hold it for its generally cautious approach and long-term record of capital preservation.

There’s an update on the portfolio as a whole in our Isa supplement (out 18 March) in the magazine (RIT stays in it!) but we were pleased to see that RIT’s just released final results back up the case for continuing to hold it.

It saw a total net asset value (NAV) return last year of 23.6% against 20% for the MSCI AC World Index – not bad given that the trust has relatively low overall equity exposure. This year hasn’t gone so well (for anyone).

The shares are currently off 10% in the year to date and trading on an 8% discount to their NAV. However the trust remains nicely defensive – only 35% in equities with hedges in place in the more expensive software stocks alongside a rising exposure to European value and to commodity sensitive positions, for example.

The managers note that they expect 2022 to be a tricky year, but also that, while “volatility can often feel uncomfortable... the flipside is that if markets react indiscriminately this can also provide opportunities”.

The analysts at Numis remain fans. They approve of the firm’s high level of exposure to unlisted investments (now well over 30% of the portfolio) and its careful approach to new positions.

The result of this has been a long term NAV total return of 11.3% a year, something that is “significantly ahead” of global equity markets, as well a tendency to participate in most of the market upside (74% of the tie since launch in 1988) and not much of the downside (38%).

It is an exceptional long term record – and the reason why it is staying in our portfolio, and staying as the “core long term recommendation in the Global Investment Companies sector” from Numis.

At first sight, 2021 was a disappointing year for investment trust performance.

The Closed-End Investments index returned a very respectable 12.8%, but this was 5.5% behind the 18.3% return of the All-Share index. Meanwhile, the MSCI AC World index, boosted by the 28.1% return from the US, returned 20.1% in sterling.

This followed a 2020 in which the Closed-End index returned 17.8% – 27.6% ahead of the All-Share index, the largest gap in 30 years. This caused many UK institutional investors to complain about the inclusion of investment trusts in the All-Share index, arguing that it caused them to underperform, which was unfair.

Yet in 2021, after that stellar 2020, investment trusts held the All-Share back. What happened?

Why was 2021 a tougher year for investment trusts?

The average discount to net asset value (NAV) for investment trusts fell from 1.7% to 1.5% during 2021, so the underperformance cannot be explained by widening discounts. Indeed, a record £12.2bn of new capital was raised for existing trusts and a further £4bn for 15 new issues.

This, together with performance and after deducting some returns of capital, raised industry assets to an all-time high of £227.6bn, according to the Association of Investment Companies (AIC). Net capital raised of £14.9bn was, according to JP Morgan Cazenove, 247% higher than in 2020. This, alongside the low discount to NAV suggests no loss of investor confidence in the sector.

Although most of the equity component of the sector, especially the global funds, is growth orientated, this was not necessarily a problem. Though value shares, which had lagged badly in 2020, outperformed growth, the gap was narrow. The MSCI World Value index in sterling returned 23.9% and Growth 22.5%.

What held the sector back, according to JP Morgan Cazenove estimates, was primarily asset allocation, ie, too much exposure to lagging sectors. Stock selection, gearing (borrowing) and non-UK exposure all helped performance relative to the All-Share index.

The average return of trusts in the UK commercial property sector was 30.2% and seven funds in the broader property sector returned over 40%. Private equity, where value was abundant both in valuations and discounts, the return was 42%. The property and private equity sub-sectors account for £20bn and £27bn by value, over 20% of the total.

The performance of the growth trusts, however, lagged. Technology trusts (£7bn by value) returned 19% while the Dow Jones Technology index returned 30% in sterling and healthcare trusts (£6.4bn by value) returned a weighted average of -5.3% compared with a 21% sterling return from the MSCI World Healthcare Index. The poor performance of biotechnology shares, over-represented in the investment trust sub-sector, was a significant factor in this underperformance.

Growth-orientated generalist trusts also under-performed. The giant Scottish Mortgage Trust, valued at over £20bn, returned 10.5% – but it had more than doubled in 2020. Its performance in 2021 was way behind that of global indices. Sister trust Monks, with £3.3bn of assets, returned just 1%. Baillie Gifford’s other trusts also lagged badly, notably Edinburgh Worldwide (-21%), UK Growth (8%), European Growth (4%), US Growth (-5%) Japan (-10%) and Shin Nippon (-17%). Pacific Horizon (15%), though, had a surprisingly good year (more on that below).

Why did these and other growth managers perform poorly? Probably because they switched into up-and-coming growth stocks at the expense of what Ed Yardeni calls “the magnificent eight” at the top of the S&P 500, which continued to storm ahead. In 2022, though, it may be a different story.

Investment trust performance overall was also held back by the steady returns of much of the “alternatives” sector, which now accounts for approaching half of the total. While private equity and most property funds did well, the weighted average return in the renewable energy sector (valued at £15bn) was 8%. It was no higher in the rest of the infrastructure sector (valued at £17bn) with the honourable exception of 3i Infrastructure (+19%). Most debt funds also produced modest returns, in line with their targets.

How China hit returns in emerging markets

President Xi’s crackdown on the private sector caused a bear market in Chinese equities with the MSCI China index falling 20%. Whether the outlook for investment in China will worsen, stabilise or improve is probably the major uncertainty of the next few years. China, excluding Taiwan, accounts for 31% of the MSCI Emerging markets index and 37% of the Asia ex-Japan index (Hong Kong is regarded as a developed market so companies listed there are not included in emerging markets but are a further 7% of Asia ex-Japan). The drag of China resulted in small falls in both indices.

Despite this, some trusts in the sector performed remarkably well, notably those specialising in India, Vietnam and Frontier Markets. The three Asian smaller companies funds, whose benchmarks have much lower exposure to China, also did well. The scepticism towards Chinese companies of Mobius Investment Trust (+12%) and Pacific Assets (+15%) paid off but the 16% return of Baillie Gifford’s Pacific Horizon Trust was the most remarkable, as it followed a 133% return in 2021.

Also remarkable was the 35% return of RIT which sets out to lag on the upside in order to protect on the downside. Caledonia (+44%) did even better. Both benefited from the success of their private equity investments. Among the global trusts, strong investment performance, but no private equity, resulted in AVI Global, Mid-Wynd and Brunner returning over 20% while nearly all small cap trusts in all markets except Japan performed well.

Many of the UK funds beat the All-Share index with Merchants (+32%) and Fidelity Special Values (+27%) in the lead. The same was true in Europe where BlackRock Greater Europe (+32%) led the pack and the 6% appreciation of sterling against the euro did not appear to hold returns back.

Overall, there were plenty of triumphs, some disappointments but very few disasters. Good fund managers do not churn their portfolios or make radical changes to their investment styles so it is not surprising that some of the heroes of 2020 had a disappointing year. In contrast, most of those that struggled in 2020 were rewarded in 2021 by better market conditions for their specialities and styles.

The bears believe that persistent inflation and rising interest rates will make 2022 a difficult year; the bulls that economic growth will support the uptrend in corporate earnings and that a return to normality in monetary policy is healthy. Whoever is right, investment returns, both for growth (but not at any price) and for value investors, are likely to be healthy over the next five years, which should be the horizon of most investors.

“Value versus growth” is one of the easiest frames through which we can look at investing styles. Yes, it is a simplistic divide (see below): no investor can ignore valuations nor how earnings are likely to evolve. But it still says something about the psychology of an investor: do you favour a solid chance of profits today or the riskier possibility of a bigger gain in the future?

Splitting markets into growth and value also shines a useful light on trends. The MSCI World Growth index has beaten its value counterpart by six percentage points per year over the past decade, which is remarkable, but by more than sixteen points per year over the past three years, which is barely believable. With the growth index now on a forecast price/earnings of almost 30, compared with 13 for value, it’s hard to see how that can be repeated.

Investors want excitement

Value against growth is not the only long-standing anomaly to struggle lately. History also suggests that stocks with lower share-price volatility tend to outperform more volatile ones on average, yet the S&P 500 Low Volatility index (which holds the 100 least volatile stocks in the main US benchmark) has lagged the S&P 500 by 3.5 percentage points per year over ten years and almost ten percentage points per year over the past three years. No matter how you break it down, you can see the preference for glamorous, volatile growth stocks over anything duller.

Yet neither value nor low volatility have performed badly in absolute terms. The World Value index has returned an acceptable 9%-10% per year over three, five and ten years. The S&P 500 Low Volatility has returned 15% per year over three years and 12%-13% over five to ten years. This makes it hard to be confident that we can expect value stocks or low-volatility stocks to do well in absolute terms when the environment changes, because in many cases they have not done worse than expected up to now – they’ve simply been outstripped by a boom in growth.

In particular, much of the return from value stocks usually comes from improving valuations as investors become less negative about their prospects, not through growth or increased profitability (see the chart above from Verdad Capital, which shows that about two-thirds of the total return in US value over the last 25 years came from changes in valuations). Today, value is not especially cheap in absolute terms, even if it is relatively cheap compared with growth. That will make it harder to benefit from the tailwind of improving valuations. Thus while value – and low volatility – will probably do better relative to growth, only a few genuinely unloved sectors (perhaps oil) seem likely to deliver impressive absolute returns.

The difference between growth stocks and value stocks

Investors in stocks can follow a number of distinctively different approaches – often referred to as styles – when deciding which companies to buy. The two styles that are most frequently used to classify investors are growth and value.

Growth investors look for companies that are expected to grow their earnings faster than their sector or the wider market. They will often be willing to buy shares on valuations that appear quite high compared to other companies if they believe that these may be justified by future profits. This approach places more emphasis on the firm’s potential, as opposed to its current financial situation.

Value investing is the opposite. Value investors focus on companies that appear to be cheap today (or sometimes stocks that should be cheap in the very near future if the business recovers after a recession or crisis). While growth investors are typically mostly concerned with earnings, value investors will often look for stocks that trade at a discount to book value (assets minus liabilities) or offer high dividend yields.

Some investors view the distinction between growth and value as artificial. A successful growth investor still needs to be confident that a company is not so overvalued that its earnings can’t justify the price they are paying. A value investor needs to consider whether a stock is cheap because the underlying fundamentals of the business are faltering and will lead to reduced profits, financial distress or bankruptcy in future.

That said, growth versus value provides an easy way to divide the market into stocks that are popular and high-priced and those that are out of favour and trade on lower valuations. Historically, the value segment of most markets have tended to beat the growth segment over the long run (which may be attributed to exuberant investors overvaluing potential growth). However, in the past decade, growth has handily beaten value.

It has been a year to forget for investors in most emerging markets. Developing countries’ populations have received far fewer vaccinations than their developed-country peers. Economies are vulnerable to inflation and with government borrowing rising, the asset class is increasingly out of favour with international investors.

Last month, “non-resident [financial] flows to emerging market assets excluding China turned negative” for the first time since March 2020, say Kate Duguid and Jonathan Wheatley in the Financial Times. Investors’ enthusiasm for emerging markets has dwindled this year and 2022 may not prove much better. Many emerging markets are caught between a Chinese slowdown on the one hand and tighter US monetary policy on the other. Higher US interest rates strengthen the dollar, making it difficult for countries such as Turkey, Brazil, South Africa and India to secure the credit they need as money heads to the world’s biggest economy.

Crushed by China

As of mid-December, the MSCI Emerging Market index has fallen by more than 4% since the start of the year, badly lagging the 18% average gain across developed stockmarkets. That decline has been driven by China, which accounts for more than one-third of the index. China’s benchmark CSI 300 index enjoyed a stellar 2020, rising 27%, but is down by 4% so far this year amid a regulatory clampdown on tech companies and concern over an overheating property market.

India has delivered a standout performance in 2021, with the BSE Sensex index returning 21.4% amid excitement about technology flotations. The country boasts compelling long-term growth prospects, but investors have to pay up for them. On a cyclically-adjusted price/earnings ratio (Cape) of 33.8, India is almost as expensive as the US market.

South Africa has also delivered a strong performance, with the FTSE/JSE Top 40 rising by almost 20%. The commodities boom has boosted stocks in the nation that produces 80% of the world’s platinum-group metals. South African stocks have gained 26.5% since the start of 2020.

Turkey’s self-inflicted currency crisis has seen the few remaining foreign investors flee. Yet on the face of it the local BIST 100 index has had a banner year, gaining 44%. The problem? That is in local-currency terms and the lira has lost half of its value against the dollar this year. In dollar terms, the MSCI Turkey index has slumped by 27% in 2021.

It has also been a disappointing year in Latin American markets. Most commodity exporters have done well this year, but Brazil has failed to benefit, with the local Ibovespa down almost 10%. Copper producer Chile has had another bad year amid political turmoil. The local IPSA index has fallen by almost a fifth since the end of 2019, including a 3% fall in 2021.

Boosted by resilient oil prices, Russia’s MOEX index has had another solid year, gaining 4.9% on the back of a 6% gain last year. Elsewhere in eastern Europe, Poland’s WIG20 index has returned a creditable 10%.

Korea calms down

Delta has ravaged regional supply chains this year, but much of East Asia has still bucked the wider sell-off. With semiconductors in short supply, Taiwanese chip makers have had an excellent year, helping send the Taiex stock index up 18%. Thailand’s SET index has risen by 11%, making up for last year’s disappointing 8% fall.

Elsewhere in Southeast Asia, Indonesia’s IDX Composite is up by 5.6% and the Philippines PSEi index has risen by 1.4%. Vietnam’s VN-index has delivered a blistering 33% return, but emerging-market investors won’t feel the uplift: the country is still classified by MSCI as a “frontier” rather than an “emerging market”.

Korea’s Kospi index was last year’s star performer, with a 30.8% gain, but foreign investors have now cashed in their profits. The removal of a short-selling ban earlier this year by local financial regulators has also put stocks under pressure, leaving the home of Samsung with a modest 1.5% gain for the year.

Everyone likes to think that they’re indispensable. When Randolph Churchill resigned as chancellor in 1886, he expected to bring down the government. But his successor George Goschen did at least as good a job as he had done. Churchill’s career and reputation was ruined and he later admitted: “I had forgotten Goschen.”

So Jacob Rothschild may have mixed feelings about the success of RIT Capital Partners (LSE: RCP) since he stepped down as chairman in 2019. His family, who account for over 25% of the £4.2bn company, clearly benefit from the strong performance, but he may be put out that the management team are doing very well without him. Investment returns of 18% over the six months to June 2021, and 42% over 12 months, are among the best in the global sector and far ahead of the 12% and 26% returns of the MSCI All Countries index in sterling.

New investments delivering

RIT aims to deliver long term capital growth while preserving shareholders’ capital. It seeks to outperform the relevant indices “over time”, but expects to fall behind in rising markets. “RIT has slightly lagged the reference index over the last five years (to 30 June) but the volatility of performance and correlation to the index is low,” notes Chris Brown, an analyst at JPM Cazenove. The trust’s performance has accelerated in the last year, but its shares were still trading on a 6% discount to net asset value this week.

This acceleration is largely due to the success of private equity investments, which contributed 13% of the overall 19% return in the first half. Private equity accounts for 29% of the portfolio but this excludes Coupang, the Korean e-commerce company, which listed in March and surged 40% on its debut. It accounted for 9% of the portfolio at mid-year, though its share price dropped 13% in July. It contributed 5.5% towards the first half’s overall performance.

There were several other positives in the private equity section, which includes exposure to funds as well as direct investments. A £29m new investment in stock trading platform Robinhood is doing well and the £50m investment in Webull, another trading platform in the US, looks promising. Rothschild’s absence is not limiting RIT’s access to good deals round the world; the management team are well connected and the Rothschild name is still a door opener.

The quoted equities portfolio, which accounts for 52% of the total, contributed 6% to the overall return. There has been a shift towards defensives, which might help reduce the volatility of returns, including consumer goods producers Unilever and Reckitt Benckiser. A further 20% of the portfolio is in absolute return and credit investments, which contributed 1.6% to the overall return.

Bolder decision making

The changeover from Rothschild to a younger generation has probably resulted in increased boldness in the decision making. It is hard to imagine RIT under Rothschild investing in Coupang or Robinhood, or allowing a gearing (debt to equity) ratio of around 10%. Clearly, management is positive about the outlook for the portfolio.

The only negatives are a tendency to over-hedge currency exposure into sterling (49% of the portfolio at the half year) which is costly when sterling is weak. At 1.6% fund costs are high, thanks to investment in third party funds, and there is also a management incentive scheme. These costs are an issue for many wealth managers who charge their clients additional fees, but direct investors should only be concerned about net performance, which is excellent.

My scepticism late last year was wrong. RIT should be a key building block of any investment trust portfolio.

The investment world has reacted with horror to the idea that Chinese communist policy makers and regulators might not be enthusiastic about large private companies with too much pricing power.

The regulatory clampdown on online education platforms and tech giants such as Tencent and Alibaba has had an inevitable knock-on impact on the price of the leading UK-listed China funds.

The good news, however, is that all of the China-focused funds are underweight the tech giants compared with the weighting of over 30% in the MSCI China on 30 June.

In particular, Numis analysts note the “approach of Stewart Investors, manager of Pacific Assets, means that it has no exposure to the tech giants, which have not typically met the manager’s definition of quality”.

Rotating away from tech

Perhaps the biggest surprise, according to Numis, is the low exposure of Pacific Horizon – managed by Baillie Gifford – to these stocks given the group’s explicit focus on growth.

However, over the last 18 months the portfolio underwent a significant rotation away from Chinese tech towards more cyclical companies, including materials stocks, and exposure to India was increased.

The Numis analysts looked at funds’ returns between 22 July and 28 July, when market volatility peaked. The biggest falls came in JPMorgan’s China Growth and Income fund (down by over 12% in net-asset-value, or NAV, terms) with the Baillie Gifford China Growth and the Fidelity China Special Situations trusts not far behind.

The JPMorgan fund now trades at a 5% discount to NAV while its peers are still on premiums. As Numis observes, this is odd given “its exceptional track record through a growth approach in recent years”.

We may now be past the worst. Jimmy Chen, a manager based in Hong Kong for the Comgest Growth China fund, reckons that the market has overreacted to China’s recent regulations and that the Chinese regulatory environment has not actually undergone significant change.

Many of the new or rumoured regulations should have a limited impact, including those on property, food-delivery or the internet, with only private after-school tutoring (AST) companies being severely impacted. Chen also notes that there have been regulatory turnarounds before but what’s different this time is that “the new regulations have hit

some of the large-cap growth companies and sectors owned by foreign investors”.

If he’s right, some of the worst-hit stocks in the last few weeks are now cheap. Take Tencent, which has been getting a kicking as the regulators fret about the impact of video-gaming on the young. The share price has slumped by 40% from its January peak. That puts its shares on a price/earnings (p/e) ratio of around 20, which isn’t very expensive for a diversified internet conglomerate.

The negative scenario

So much for the optimistic take. But what if this regulatory drag net is just the beginning? Ollie Parsons of investment advisor Ravenscroft says that new sectors might find themselves in the firing line. Top of his list is healthcare; witness the 20% dip over two days in the Hang Seng Healthcare Index. According to Parsons, “it is no shock to see the healthcare stocks with a technology overlap being amongst the worst hit, stocks such as JD Health International and Alibaba Health Information Technology”.

He also reckons real estate could be in the firing line – again – as policy makers worry about rising property prices. If so, that could throw a spanner in the works of the next great potential China land grab by foreign investors: the real estate investment trust (Reit) market. Asia-focused fund manager Eastspring has suggested that the rise of onshore Reits was a big positive move, providing a new financing channel “for infrastructure projects from the public to the private markets. This new asset class will widen the range of long-duration assets available to Chinese savers and supplement pension and life insurance investments.”

New property investments

Chinese regulators are even contemplating commercial property Reits (offices, shopping malls, logistics and residential housing) which could rapidly become “a $3trn Reit market, overtaking the US, currently the world’s largest Reit market and far outpacing the rest of Asia”.

Which sectors are safe?

So what should investors do now? One option is to focus on the sectors where the Chinese communists are keen

to see increased investment, some of it foreign. Chinese-American venture capitalist and blogger Lillian Li runs an excellent blog called Chinese Characteristics, which looks at what works – and doesn’t – in Chinese tech.

She suggests that we should be looking at the current five-year plan for the sectors identified as key sources of future growth. These include new generation artificial intelligence, quantum information, integrated circuits (or semiconductors), neuroscience and brain-inspired research, and virtual reality.

Will GDP growth accelerate?

Finally, consider also the wise words of a Chinese-based American economist called Michael Pettis, who writes a widely read newsletter called GlobalSource. He’s regarded as the gold standard for macro-economic analysis in China and one of his latest notes suggested that we might expect much more pump priming to get

the Chinese economy moving even faster.

Pettis observes that “while I continue to expect China’s reported GDP growth for the year to be between 6% and 8%, I am starting to believe that it will be much closer to 8% than 6%. This is because there are signs that Beijing will allow investment in infrastructure and the property sector to pick up speed in the second half of the year.”

Frightening the bearers of global capital – and struggling with the Delta wave at the same time –

might give the government second thoughts about appearing too communist. If so, we may be able to look forward to a healthy rebound in the growth rate in the fourth quarter.

Few places have suffered as much from the Covid-19 pandemic as Latin America. Of the top five countries by total reported deaths globally, three – Brazil, Mexico and Peru – are in the region. Weak healthcare forced governments to implement very strict lockdowns last year, says The Economist. Tight budgets have constrained stimulus efforts. The result? GDP in Latin America and the Caribbean fell by 7% in 2020, compared with a global average contraction of 3%.

Latin America came into the crisis with “pre-existing conditions”, says Eric Parrado on Project Syndicate. Productivity has lagged more successful countries for decades. High commodity prices after the financial crisis gave Latin American governments an opportunity to turn things around. But they put reform “on the back burner” and raised spending on subsidies rather than infrastructure.

A bet on commodities

The region’s market is exceptionally cyclical: energy and materials stocks make up 34% of the MSCI EM Latin America index; financials comprise 23%. Information technology accounts for just 1.8%. Weak commodity prices have made this a miserable decade. The MSCI index has fallen by 40% over the last ten years in dollar terms. The recent commodities rally had given shares a boost, but that too has cooled, leaving the index up by just 2% so far this year. Brazil makes up two-thirds of the index, while Mexico accounts for just over a fifth. The remainder is largely made up of Chile, Peru and Colombia.

On a price/earnings (p/e) ratio of 13.6, stocks are certainly cheap, but they don’t look so attractive given the risks, say James Norrington and Mary McDougall in the Investors’ Chronicle. The region’s politics have turned ugly; “horrifyingly, 91 politicians were killed, including 14 candidates”, in the months before Mexico’s legislative elections. Brazil’s election next year could see divisive president Jair Bolsonaro square off against former leader Lula da Silva, another polarising figure. “A Marxist-Leninist is poised to become Peru’s next president”, adds Ruchir Sharma in The Financial Times. A communist could also come to power in Chile. Still, history shows that the region’s economic fortunes depend on one thing: commodity prices. The economy boomed along with commodities in the 1970s and the 2000s. Bad decades for raw materials, such as the 2010s, are “often the harbinger of a better one to come”. A sustained commodity rally would negate worries about the latest crop of populists.

Not so fast, say Norrington and McDougall. Shares are cheap and could benefit from a cyclical boom, but “many of the attractive elements offered by Latin American economies… are also present in other emerging markets with less political risk.”

Passive investing – where an investor aims to match the return on an underlying market rather than beat it – has grown relentlessly in popularity over the last two decades. Little wonder. Passive funds cost far less than actively managed ones and mostly deliver better performance, because only a minority of active funds beat the market over time. Now index provider MSCI is working on the “ultimate index” – a project that “could mark the culmination of half a century of academic theory and practical financial engineering”, writes Robin Wigglesworth in the Financial Times. It aims to benchmark not just equities or bonds, but also “commodities and even private assets that do not trade on an exchange”.

A tracker fund that offers exposure to every major asset class sounds a convenient way to take the headaches out of asset allocation (see below). But as the man behind it, former theoretical physicist Peter Shepard at MSCI, points out, “one size will not fit all investors”. Asset allocation has to fit each individual’s circumstances: risk appetite and time horizon being the two main variables.

Another issue is complexity. It’s easy to tie yourself in knots given the range of apparently different asset classes out there. What role should currencies play? Hedge funds? Private equity? Faced with these questions, Shepard says, “simplicity and transparency are key. I could come up with a great black box, but if you don’t understand it, you won’t trust it and you won’t use it”. So keep your asset allocation simple. We’d suggest building your portfolio around five basic asset classes: equities, bonds, property, gold and cash, with the lion’s share in the first two. The point is for each asset to bring something different to the mix. Equities are a good play on long-term growth. Bonds are good in periods of deflation and weak growth. Property is basically a form of equity (an ownership stake rather than a loan), but with an element of inflation protection. Gold works as a disaster hedge and cash affords flexibility (“optionality”).

Any other asset class you can think of slots into one of these boxes. If you decide private equity is something you want to own (perhaps via listed private-equity funds or investment trusts), it just sits in your equity allocation. It’s the same for commodities – while you can get direct exposure (see page 18), the reality is that mining stocks are a good enough approximation for most of us. As for currencies, they aren’t a separate asset class – they are better thought of as a potential cost you should be aware of when investing in non-sterling assets. Meanwhile, if MSCI or another index provider ever does come up with the “ultimate index”, you could always use it as a benchmark with which to compare your own portfolio’s performance.

Asset allocation is the process of dividing your portfolio between different asset classes, such as shares, bonds, property, cash and gold. Each of these asset classes should behave in different ways in different scenarios and have different potential risks and returns. The aim of asset allocation is to blend these together in a way that produces a combined level of risk and return that best suits an investor’s needs.

To take some extreme examples, a young investor saving for retirement a long way in the future and prioritising maximum growth above everything else might have 100% in shares, while a retiree who only cares about achieving a steady income might have 100% in bonds.

More commonly, somebody who wants to achieve a combination of income and growth while also protecting their wealth from bear markets would typically have a portfolio split between different assets classes in a more balanced way.

I wish I knew what asset allocation was, but I’m too embarrassed to ask

Asset allocation is often divided into strategic asset allocation and tactical asset allocation. Strategic asset allocation is essentially what we’ve already described – how you allocate your money for the long term to fit your investment goals. Over time, the amount in each investment may drift away from your strategic asset allocation because some asset classes have performed better than others. So on a regular basis – maybe once per year – you will rebalance your portfolio to take it back to your original strategic asset allocation.

Tactical asset allocation is any temporary changes that you make to a strategic asset allocation as a result of current market conditions. If shares sell off a long way and now look cheap, you might choose to reduce the amount of cash you hold and increase your investment in shares. Profiting from tactical asset allocation is harder than it sounds and doing it too much can easily lead to higher costs and lower returns.

The banking sector has been a significant drag on the UK market. Since 2006, the All Share index has risen by 19% but the five banking constituents of the FTSE 100 have, on average, fallen by 70%. As Nick Brind, co-manager of the Polar Capital Global Financials Trust (LSE: PCFT), notes, this was not just the result of the financial crisis. Since mid-2013, the five have slipped by 30% while the All-Share has returned 46% and the MSCI Global Financials index 77%.

A difficult domestic market

It’s not hard to see why. With interest rates at zero, it is virtually impossible for UK banks to make sufficient margin to cover costs, bad debts and a reasonable return on capital. Fee income is under relentless pressure from specialist providers of insurance, investment advice and foreign exchange, competition in the commercial market is intense and investment-banking income has withered. Regulators stopped banks paying dividends in 2020 and their overall rate of corporation tax is 8% higher than standard. “UK banks are not a good guide to the opportunities in the sector,” says Brind.

Banks in the US and emerging markets have fared better so PCFT has prospered, returning 102% since mid-2013 and 54% since the trust survived a continuation vote at the cost of buying in 40% of its shares last April. This has led to an acceleration in relative performance, which has been 14% ahead of the global financial index since then. The shares now trade at a small premium to net asset value (NAV), enabling PCFT to reissue most of the shares it bought back. Assets have increased to £250m and though the yield has dropped below 3%, dividend growth is likely to resume this year.

Over 90% of PCFT’s portfolio is outside the UK; 63% is invested in banks, 14% in insurance, and 10% in “financial technology” (such as PayPal and Mastercard). Nearly half of assets are in North America and 20% in Asia ex Japan. The sector has started to outperform but Brind believes there is much more to go for.

“Banks underperformed in the pandemic by more than in the global financial crisis,” he says, “but the rise in loan losses has been muted while payments of deferred interest have resumed. US banks are incredibly well reserved so provisions are likely to be released in 2021-2022 , enabling a resumption of share buybacks.” A strong recovery in earnings is expected, helped by the steepening of the yield curve. “This is very good news for the sector as the performance of banks is highly correlated to bond yields.”

Rising interest rates bode well

A 1% rise in US interest rates, says Brind, causes bank earnings to rise 12% in year one and 20% in year two. The discount of share prices to book value for global banks has narrowed from 30% to 10% but Brind sees 20% upside in the US and 30% globally, with asset values boosted by the release of provisions as well as by earnings. Given how well the banks withstood this crisis, it is even possible, he thinks, that they could be rerated in a more benign regulatory environment.

Exposure to emerging markets has been reduced despite the structural growth opportunities and a sector that is “more profitable and more dominant than in developed markets”. Financial technology companies have benefited from an acceleration in the shift of transactions online while pricing in insurance markets is firm. Covid-19 losses are estimated at $60bn-$70bn but balance sheets are strong and valuations moderate.

Financials usually out-perform by 23% in the 12 months from market lows, says Brind, “but have barely outperformed since the Covid-19 low and have halved relative to the MSCI World index since 2006”. Given the encouraging outlook the trust is geared, with borrowings of 9% of net assets.

The three investment trusts specialising in China were among the 20 best-performing trusts in the whole market last year. And if you believe the managers, there is much more to go for. JPM China Growth & Income Trust (LSE: JCGI) returned 96%, Fidelity China Special Situations (LSE: FCSS) 69% and Baillie Gifford China Growth (LSE: BGCG) 56%, although it only switched to Baillie Gifford in September, having previously been called Witan Pacific. FCSS shares trade at net asset value (NAV), but the other two at a premium.

Roddy Snell, co-manager of BGCG, points out that “China accounts for 19% of global GDP at purchasing power parity, 18% of global market capitalisation and 31% of the world’s listed stocks, but only 5.5% of the MSCI All Countries World index. The allocation of most global funds is just 2.5%”. Catherine Yeung of Fidelity International draws attention to the Middle Kingdom’s strong economic fundamentals, such as “a 37% savings ratio, 2.3% growth in 2020 and 8%-9% this year, falling to 5.4% next. Household debt is low, the labour market tight and credit growth is decelerating as monetary policy is normalised”.

A structural slowdown

Rebecca Jiang, manager of JCGI, says that “better-quality and more sustainable growth will lead to a structural slowdown” compared with the breakneck pace of earlier decades. Meanwhile, “a market that is broad and deep, young and volatile creates many opportunities to invest in mispriced stocks. It’s a great market for bottom-up stock selection.” Her focus is on “technology and innovation”, with 17% invested in information technology and 18% in healthcare, each 11% above the China-index weighting. The two largest holdings, Tencent and Alibaba, both among the ten biggest companies in the world, account for 16% of the portfolio between them, but are categorised in other sectors despite their main businesses being in e-commerce and internet-related services. With 85% of the portfolio in companies with a market value above £10bn, this is a large-cap portfolio.

FCSS, by contrast, concentrates more on smaller companies with just 38% of the listed portfolio in large caps and 24% in companies with a market value below £1bn, where JCGI doesn’t venture. Tencent and Alibaba are each over 10% of the portfolio, but these two stocks, which account for 28% of the China index, are hard to ignore. As Yeung says “small caps have lagged in recent years, but there has been some bounceback recently.” This will have held performance back but, unlike JCGI, FCSS leverages the portfolio through futures and options to achieve net equity exposure of 119% of net assets, which has boosted returns. The portfolio is less growth focused than JCGI, but “the price/earnings (p/e) ratio in the mid-20s is similar to the market. The earnings cycle is turning positive so the party is not quite over, but investors need to be alert”.

Unlisted stocks account for 7% of FCSS’s portfolio, but “could be 15%-20% of BGCG”, says Snell. BGCG is very much a growth fund, investing in between 40 and 80 firms. At present, 4% of the portfolio is in ByteDance, the owner of TikTok. “If you’re not looking for growth companies, you are missing the point of investing in China,” Snell says. Eighteen percent of the portfolio is invested in Alibaba and Tencent, but Snell is getting more interested in “the second wave of innovation” in the internet sector. Baillie Gifford has opened a Shanghai office to research “the many firms not looked at by overseas investors in a retail-driven market. This will be the largest economy in the world and we are only at the beginning in investment terms”.

All the managers claim to be rigorous in applying environmental, social and governance (ESG) scrutiny to their stocks. “ESG is crucial to what we do,” says Snell. But is it really? China’s abuse of the Uighurs, aggression towards India and in the South China Seas, crackdown in Hong Kong and increasing belligerence towards Taiwan don’t seem to matter when it comes to testing ESG. President Xi’s promise of carbon neutrality by 2060 is accepted without question, but 2060 is a long way away. Diana Choyleva of consultancy Enodo Economics points out that despite China’s pre-eminence in renewable energy industries, more than half of China’s electricity is generated by burning coal.

Moreover, “in 2020, China put into operation more than three times the amount of new coal-fired capacity built elsewhere around the world”, she says. Besides, to whom is President Xi accountable at home and abroad if he fails to pursue that target? Hong Kong shows how easily China’s commitments are broken and its response to Covid-19 how little regard it has for openness and honesty.

It gets much worse. “China is determined to absorb Taiwan,” says Choyleva. “Xi sees reunification as a national duty that falls to him. Only coercion followed eventually by a military invasion would bring about reunification. The far-reaching geopolitical confrontation between the existing superpower, the US and the aspiring one, China, is neither going away or diminishing. We see only a 40% chance of avoiding conflict in the next three years.”

Could China face major turbulence?

And what of North Korea? Is it China’s embarrassing neighbour or its poodle? It too could turn aggressive if given the opportunity. Admittedly, these are threats to all world markets, not just China, but investors in China need to keep their rose-tinted glasses glued on. The inevitable and growing strains between an authoritarian communist government and an entrepreneurial economy spreading prosperity and aspiration across China will not necessarily be resolved peacefully and favourably.

For those who regard investing in a pure China fund as a step too far for reasons to do with ethics, ESG, or disbelief in the sustainability of the Chinese economic model, there are good alternatives in the broader Asian ex-Japan market – although Asian trusts will usually reduce rather than avoid exposure to China.

The star of this sector is Baillie Gifford’s Pacific Horizon Trust (LSE: PHI), managed by Ewan Markson-Brown. Like other Baillie Gifford managers, he is a growth investor, seeking companies that can generate expansion rates of 15% per annum for three to five years. He points out that while analysts’ earnings forecasts are generally too optimistic, they tend to underestimate the fastest growers. PHI returned 129% last year and 278% over the last five years. As a result, its shares trade at a significant premium to NAV. China (including Hong Kong) currently accounts for 40% of the portfolio, but that is well below the regional index’s 52%.

What is most notable is that the portfolio’s top ten include neither Tencent nor Alibaba, nor the other two big index components, Taiwan Semiconductor and Samsung, though PHI does hold Samsung’s SDI affiliate, a global leader in lithium-ion batteries.

“This is the Asian growth decade,” Markson-Brown says, “but the growth opportunities stretch well beyond the technology sector.” He notes that Baidu’s share of internet searches has fallen from 50% to 10%, while Tencent’s share of social-media advertising has dropped from 80% to 40%, thanks to TikTok. “Big tech growth is slowing,” he says, “while competition is increasing and regulation tightening.”

Instead, he has been buying Tata Motors, owners of Jaguar Land Rover, as “it has taken out costs and is developing new electric models”. Tesla has changed the business model for making electric cars, showing that it can be far more profitable for Jaguar Land Rover, than expected. Chinese sportswear company Li-Ning, meanwhile, “threatens Nike and Adidas. The Chinese increasingly favour local over international brands”.

The records of Schroder Asia Pacific (LSE: SDP), Aberdeen Standard Asia Focus (LSE: AAS), JP Morgan Asia Growth & Income (LSE: JAGI) and Invesco trusts are similar, with returns of 140%-160% over five years. Schroder has done well to keep pace with only a 7% direct exposure to China (plus 29% to Hong Kong), but its veteran manager, Matthew Dobbs, is due to retire shortly. The shares of JP Morgan Asia Growth yield 3%, but the generous dividend is largely paid out of capital. JAGI wisely avoids compromising capital returns to generate income, resulting in significantly better total returns than other Asian income trusts. Its shares trade at asset value rather than the usual discount of 5%-10%.

A stellar long-term record

In recent years, Aberdeen Standard Asia Focus has been a conspicuous laggard, returning just 70% over five years, but performance has picked up in the last six months. With zero exposure to China and 8% to Hong Kong, this is the trust for China sceptics, which includes its veteran manager Hugh Young. He has always worried about the poor corporate governance of Chinese firms and their lack of openness as well as environmental and ethical issues there. It’s a small-cap trust, investing in firms with a total market value up to $1.5bn, but small caps in Asia have lagged in recent years, especially those in his favoured markets of ASEAN and India. But the long-term record has been stellar. With dividends reinvested, the shares have multiplied in value 18-fold since launch 25 years ago. They trade at a discount of more than 10% to NAV, but that will fall, adding to investors’ returns, if the good performance continues. “We are every bit as excited to invest in Asia now as we were in 1995,” says Young.

“Today, we see real resilience across Asia. It is at the forefront of global innovation and brand creation, some barely known in the UK, but often dominating their own markets. It has also learned the lessons of excessive debt, helping it weather both the global financial crisis and now Covid-19 adeptly. Governance is stronger than it has ever been, while governments across the region recognise the power of co-operation. This makes it a fertile region for active investment.”

While the developed world’s stockmarkets have been getting excited about prospects for a post-Covid-19 world, emerging-market stocks have rebounded too in recent weeks. The benchmark MSCI Emerging Markets (EM)Index has gained 8% so far this month; India and Brazil have climbed by 7% and 16% respectively.

Countries such as India, Brazil, Turkey and South Africa might now benefit from a series of tailwinds. Their Covid-19 infection rates – even without a vaccine – are already declining, which leaves their economies in better shape to expand as the developing world also stabilises. Many local stockmarkets are also cheap (especially Russia and Brazil in relative terms)and may be direct beneficiaries of a sudden turnaround in commodity prices.

A skew towards east Asia

Prospects are thus beginning to look a tad brighter for emerging markets. However, investors in this broad global sector need to keep in mind its skew towards east Asia.Three Asian countries – China, Taiwan and South Korea – now dominate the MSCI EM index, comprising over two-thirds of its value. These three economies are closely intertwined, with a strong technology bias. All three have also weathered the Covid-19 pandemic well. Traditionally important countries such as India – worth 8.15% of the index – and Brazil, just 4.39%, have almost become afterthoughts.

This focus on the three Asian economies can be seen in leading actively-managed funds such as the long-running (and outperforming) JPMorgan Emerging Markets Investment Trust (LSE: JMG). It is currently weighted towards China, which comprises 33% of the portfolio (it is underweight the benchmark index); Taiwan makes up 22.9%, (overweight); and South Korea 6.4% (overweight). Add these three up and we’re not far off that two-thirds level. The managers are overweight Russia and Mexico, however.

Now consider two other less established but equally high- performing global emerging-markets funds and we see a radical divergence. The Mobius Investment Trust (LSE: MMIT), which is trading at a 5.7% discount to its net asset value (NAV), has its biggest holdings in India (24.3% of the portfolio) and Brazil (14.6%). The three Asian economies represent only 35% of the fund. Turkey, meanwhile, is clearly overweight in this fund. It’s a similar story at the Fundsmith Emerging Equities Trust (LSE: FEET), trading at a 6.7% discount. Here India accounts for 43.5% of the portfolio – interestingly, Vietnam is overweight too, at 2.9% of the fund.

We might begin to see some of these emerging markets outperform as the global economic cycle picks up ; by contrast many investors worry that the China-dominated east Asian region might already have seen its best gains.

Investing in different national and regional economies forces you to examine the record and holdings of investment trusts in this space. I have compiled what I call my “emerging markets A-list”. It’s a collection of London-listed investment trusts boasting a solid record of beating their respective benchmarks over many years. It also gives you a wider range of country- specific funds to focus on. In my view investors might wish to consider a diverse handful of key countries (and regions) as we move into 2021. Top of that list would be India, which despite government mishaps is now well placed to race out of the coronavirus disaster in 2021. Indian stocks typically command high valuations and are quite volatile, so they benefit disproportionately from a resurgence in confidence in emerging markets. Top of my list here would be the Ashoka India Equity Investment Trust (LSE: AIE), another relatively new fund that has proved its mettle in recent months.

A runner up would be the India Capital Growth Fund (LSE: IGC), which has had a tough few years owing to some poor stock selection. However, it is now in better shape and concentrating more on mid-caps.

I also think that Russia could be a relative star in 2021 (though I also thought that in 2020, wrongly) largely because its government has more financial firepower to spur growth, especially if energy prices start to tick up. Yields of more than 5% are worth grabbing too. JPMorgan Russian Securities (LSE: JRS) may thus be worth a look.

Sticking with the theme of economies with upside potential from a rise in energy prices, there is also the Gulf Investment Fund (LSE: GIF), which invests in countries such as Qatar, the UAE and Saudi Arabia. Valuations – as in Russia – are cheap and the fund trades on a 8.5% discount (and yields 2.3%).

A market for the brave

The real wild card is Turkey, where local stocks – and the currency, the lira – have plummeted owing to a long list of worries, not least an impetuous populist leader determined to pick fights with everyone and whose mismanagement of the economy in recent years is almost legendary. But in recent weeks, there have been signs that President Erdogan realises he needs to be more realistic and reshape economic policy. You cannot buy a Turkish trust, which means you can only make this bet with the iShares MSCI Turkey UCITS exchange-traded fund (LSE: ITKY). If Turkey does turn around, this fund is ideally positioned.

UK equities performed dismally in both absolute and relative terms in the first half of the year with the FTSE All-Share index returning -17.5% while the MSCI World index gained 0.5% in sterling terms. The performance of small caps was even worse; the Numis Small Cap index (excluding investment trusts), which represents the bottom 10% of the UK market by value, returned -25%. Explanations for this included the greater domestic focus of smaller companies, the exodus from UK active funds – nearly all of which are overweight mid and small caps – and the relentless move to passive investing, which favours large caps.

Few expected or even noticed a dramatic turn-around in the third quarter. The All-Share index still performed poorly, returning -3.8%, but the Numis index returned 4.7%. Small-cap trusts matched this and mid-cap trusts did even better, yet share prices lagged with discounts to net asset value widening. Trusts that had been trading at, or very close to, net asset value are now on discounts in the mid-teens, with the exception of the long-term star performers, Throgmorton (up 72% over five years) and Standard Life UK Smaller Companies (up 75%), which are on discounts of 2% and 7% respectively.

Better than the FTSE 100

Is this scepticism about small-and mid-cap stocks justified? At the start of the year, they did not look cheap. The price/earnings multiple of the Numis index had increased to 14.9, well above the long-term average of 12.8 and only slightly lower than the All-Share index, according to Paul Marsh and Scott Evans of London Business School. The recent outperformance of small-and mid-cap specialist trusts – by up to 25% in 2019 alone – justified discounts disappearing, but it was hard to see much to attract investors in 2020.

The situation now looks very different. While the FTSE 100 is weighed down with firms that stopped growing 20 or more years ago, managers of small-cap funds are spoiled for choice. “We fundamentally believe that small- and mid-cap investors shouldn’t be looking at value,” says Roland Arnold, manager of BlackRock Smaller Companies Trust. “If companies haven’t grown historically, they won’t in the future without a catalyst for change. This means a focus on growth and quality, for which we pay a slightly higher multiple of earnings.” The managers of Aberforth Smaller Companies Trust, which is the only value fund in the sector, might not agree with that, but its five year return of -11% is not encouraging.

And investors should not be put off by current problems. “Despite the wider economic malaise, there are plenty of companies doing very well,” says Dan Whitestone, manager of Throgmorton. “The outlook for these companies is probably more compelling today than before Covid-19… There is lots of uncertainty, but there are also some incredibly exciting stocks, secular business trends that have accelerated due to Covid-19 and shares on depressed ratings with recovery potential.”

Stick with tried and tested

When equities are cheap, the best strategy is usually to buy the shares you dare not buy when they are expensive. That points to the Standard Life UK Smaller Companies Trust (LSE: SLS), one of the most growth-orientated in the sector, run by the highly regarded Harry Nimmo. JP Morgan Smaller Companies Trust (LSE: JMI), managed by Georgina Brittain, has an even better record over one and three years, while its shares trade on a discount of 15%.

The Invesco and Henderson smaller companies trusts and the three mid cap ones (JP Morgan, Mercantile and Schroders) also look attractive. But the new Buffettology Trust now being marketed does not. The record of its managers, Sanford DeLand, is excellent but it is for a fund investing across the market, not just in smaller companies. There is no reason to buy shares in a new trust without a proven record at a premium to net asset value when better value is available.

Investors sometimes use national stockmarkets as a shorthand for their views about a country, but that doesn’t mean that a given market tells you much about the domestic economy. Take the FTSE 100. It’s the key UK equity index but it’s full of firms that don’t do a huge amount of business in Britain. It’s just a collection of companies that happen to be listed in London. The same is true for many European markets and for regional indices such as MSCI Europe.

That matters because markets get hooked on narratives, and the dominant one today is that the US means growth, while Europe is boring (if cheap). These narratives are hard to dislodge, but over time they can decline in usefulness. This might be the case in Europe, according to a recent report from analysts at Morgan Stanley. They argue that European markets are changing, with new sectors becoming more important.

Bye-bye banks

Some of the highlights really stand out. The biggest sector in Europe? Banks or energy stocks? No – healthcare and especially pharmaceuticals. Technology stocks account for about 8% of the value of the MSCI Europe index, on a par with banks, which have halved in importance since 2010. Energy has also shrunk, to under 5%.

Or if we go by countries, Germany is hugely important – but not the conventional story of engineering giants hooked on China. The largest sector in the MSCI Germany index is technology (16%), with healthcare on 12%. Meanwhile, Denmark and The Netherlands are far more important to the European markets than either Italy or Spain. In fact Denmark has been the best-performing country in Europe over the last decade, driven by healthcare.

Of course, if we look at the current situation, the picture is mixed. On the plus side, the European Union is finally providing more bloc-wide fiscal safety nets, which could make a huge difference in the long term. On the negative side, while Europe seemed to be making a better job of controlling coronavirus until a few weeks ago, that’s now clearly evolving for the worse. Expect more short-term market weakness.

Investing for growth

Still, if you want to invest in the region, there’s an excellent list of first-rate funds. These include the Baillie Gifford European Growth (LSE: BGEU), which is typical of the growth-investing style of this fund house. Top holdings include Prosus (more on which shortly), Zalando (online fashion) and IMCD (speciality chemicals and foodstuffs). BlackRock Greater Europe (LSE: BRGE) has big holdings in popular growth sectors including drugs giant Novo Nordisk, Sika (a specialist chemicals business), publisher Relx and B2B tech giant SAP. I’d also highlight the BlackRock European Dynamic Fund, which has a similar strategy and profile to the investment trust. But my own personal favourite is Montanaro European Smaller Companies Trust (LSE: MTE), which invests in a growth-orientated mix of smaller businesses (disclosure: Merryn Somerset Webb, MoneyWeek’s editor-in-chief, is a non-executive director of this trust).

There’s also my parting thought, Prosus (Amsterdam: PRX). This is a weird beast. It’s the Dutch-listed international assets division of South African media firm Naspers, which is a first-rate venture capitalist that made huge profits investing in Chinese internet giant Tencent many years ago. But it is no one-trick pony: its portfolio of investments is second to none for a business listed on the public markets. You’ve got stakes in everything from familiar names such as Autotrader, Mail.Ru and Delivery Hero through to a very diversified portfolio of newer businesses. The shares trade at a big discount to the portfolio valuation, but you get a really compelling set of businesses across different sectors, all for a very reasonable price.

Tech’s growing clout in Europe

In Europe, the technology sector has surpassed the value of banks for the first time, reports the Financial Times. Ten years ago, tech accounted for just 4% of the MSCI EMU index, compared to 24% for banks, according to Morgan Stanley. Yet low interest rates have weighed on bank profitability, and the sector has tumbled by a third this year. Meanwhile, European tech stocks have advanced 11% in 2020. Hence the Refinitiv Europe technology index is now worth more (€842bn) than the banks (€822bn). A bias towards “legacy” industries such as banks has been a “significant driver” of the European market’s underperformance “over the last decade”, says Morgan Stanley. Yet with tech rising, things are changing on these bourses.

Most investors with some experience will have heard about the opportunities available in emerging markets.

But the phrase can be vague and unclear, especially for beginner investors.

While there isn’t any single definition of an emerging market, the phrase usually refers to economies that are transitioning from being relatively undeveloped towards being a fully-fledged post-industrial economy with high standards of living.

Investing in them can offer diversification away from developed regions like the US or the UK, where your portfolio may well have a lot of exposure by default, whilst still tapping into key themes like artificial intelligence (AI).

They are also strong performers. Morningstar data analysed by the Association of Investment Companies (AIC), an industry body representing UK investment trusts, showed that the average investment trust in the emerging markets sector returned 65% over the 12 months to 22 May, compared to 24% for the average investment trust.

“Emerging markets have benefitted from a weaker US dollar and strong earnings growth, as well as investors looking to diversify away from concentrated US markets,” said Omar Negyal, manager of JPMorgan Emerging Markets Dividend Income Trust.

The average emerging market investment trust has returned 60% over the last five years, and 257% over the last 10. The MSCI Emerging Markets Index returned 47% in the 12 months to 30 April 2026, compared to 29% for MSCI World (which tracks developed market companies) – though MSCI World has outperformed its emerging market counterpart over the last five and 10 years.

We take a closer look at what countries form emerging markets and how you can invest in them.

Which countries are emerging markets?

The closest thing to a universal definition of an emerging market is probably the International Monetary Fund’s ‘emerging market and middle-income’ classification, which applies to 40 countries. Some of the largest and most significant economies on this list are Brazil, Russia, India, China and South Africa, which collectively make up the ‘BRICS’ nations.

But for investors, a more relevant categorisation is MSCI, which divides national economies into five categories: developed, emerging, frontier, advanced frontier, and standalone markets. MSCI counts the following as emerging market economies:

What are the characteristics of emerging markets?

While every emerging market is different (just as every country is different), the economic trajectory of emerging markets tends to lead to some general themes that are of interest to investors.

One of these is relatively fast economic growth rates. These countries tend to be increasing their standard of living, often from a fairly low starting point, and that gives high growth rates in terms of year-on-year percentages.

That often goes hand-in-hand with improving financial infrastructure. India, for example, has gone from a predominantly cash-based economy to the world’s largest digital payments market in less than a decade, thanks largely to investment in the unified payments interface (UPI) technology that underpins the country’s payments network.

Emerging markets also tend to have younger populations relative to developed economies, and often have rapidly improving standards of education.

And particular emerging markets can offer you exposure to large structural trends, without compounding your exposure to developed markets.

“South Korean and Taiwanese markets have both been lifted by the AI boom due to increased demand for semiconductors and memory chips,” said Negyal. Similarly, he added, “companies across Latin America have been supported by stronger commodity prices and increased demand for energy and resources.”

What are the risks of investing in emerging markets?

Many of the upsides of investing in emerging markets also come with additional risk compared to developed markets.

They can be impacted by geopolitical factors, such as the trade frictions that have existed between the US and China over recent years, while fluctuations in exchange rates can be challenging for emerging economies.

The war in Iran was a headwind for emerging markets, though the peace deal agreed between the US and Iran could reverse this.

“The US is likely to face elevated inflation, potentially causing the US Federal Reserve to raise interest rates,” said Jacqueline Broers, co-fund manager of Utilico Emerging Markets Trust. “This in turn, could strengthen the US dollar, weaken emerging market currencies and undermine the macro position of many emerging economies.”

Some emerging markets also have weaker corporate governance provisions compared to developed markets, which can increase risks for investors.

And similarly, the structural trends that are currently benefitting emerging markets could hinder them should they reverse.

“Any sharp reversal in the AI theme may lead to underperformance of tech-heavy markets like Taiwan and Korea,” said Hiren Dasani, chief investment officer at Ashoka WhiteOak Emerging Markets Trust.

Should you invest in emerging markets?

With all of these factors considered, is now a good time to invest in emerging markets?

This depends on the emerging market in question. As above, all are distinct and offer different risks and opportunities.

“Emerging market equities have also benefitted from lower valuations relative to developed markets,” said Broers. While this valuation discount persists, value investors will be attracted to the opportunities in emerging markets.

Ultimately you should decide whether or not to invest in emerging markets based on your circumstances and the makeup of your portfolio – but they could offer some diversification if you currently have no exposure.

How to invest in emerging markets

If you are considering investing in emerging markets, there are several ways to go about it.

You could choose a low-cost index fund that passively tracks an index. For example:

• iShares MSCI Emerging Markets ETF (LON:0JHF) which tracks the MSCI Emerging Markets Index,
• Vanguard FTSE Emerging Markets ETF (LON:0LMP) which tracks the FTSE Emerging Markets All Cap China A Inclusion Index.

For a more active approach, investors could select an emerging markets-focused investment trust such as Templeton Emerging Markets Investment Trust (LON:TEM) or Ashoka WhiteOak Emerging Markets Trust (LON:AWEM), both of which invest in long-term opportunities in emerging market economies.

Fidelity Emerging Markets Limited (LON:FEML) is an alternative option, and can invest up to 30% of its portfolio in short positions, typically when a business operates in a sector that is experiencing a structural decline and there is some sort of governance issue surrounding the company.

JPMorgan Emerging Markets Dividend Income Trust (LON:JEMI) and Utilico Emerging Markets Trust (LON:UEM) are emerging market investment trusts that focus on dividend stocks in emerging markets; UEM is a next-generation dividend hero, having raised its dividend payout for 10 consecutive years.

Stockmarkets’ stumble last week fuelled fears of another sharp setback. So it’s perhaps worth revisiting the initial outbreak of turbulence in March to gauge what type of fund managed to provide some downside protection. The short answer is: not much at all bar some technology-focused funds. Pretty much every asset class plummeted.

Nonetheless, interestingly, one strategy does appear to have provided some comfort: investing in environmental, social and governance (ESG, see page 15 for a full definition) funds. They slipped during the sell-off, but their relative outperformance was striking.

The evidence piles up

MSCI runs a hugely popular index of world stocks, the MSCI ACWI index, which also features a variation called the ESG Leaders index. This has been outperforming the main index for years, but by 16 March that outperformance had hit record levels. Another index and research outfit, Morningstar, has compared 26 ESG index funds’ returns between 13 February and 13 March 2020 with those of their conventional peers. Returns were higher for 85% of ESG ETFs in the US market and for 100% in the context of non-US developed-market stocks.

One key measure looks at fund-flow data. French investment bank Societe Generale says that “ESG was the only equity strategy showing positive flows in the market downturn in March and... positive flows in April”. Anne Richards, the CEO of mega-fund manager Fidelity, says that the price of a share in companies with a “high (A or B) Fidelity International sustainability rating dropped on average less than the S&P 500 from its 19 February peak to 26 March. Those rated C to E fell more.”

On average, among the 2,689 companies rated, each ESG rating level was worth an additional 2.8% of stock performance compared with the index.

Analysts have several explanations for this. Many ESG funds were bullish on growth stocks, quality stocks, and healthcare-tech stocks, all of which outperformed. But most ESG funds are bearish on capital-intensive industrial and energy stocks, which plunged.

As these stocks become more expensive, they might fall out of favour and cheaper value stocks could catch up. But ESG funds’ longer-term future may still be rosy. Professor Chendi Zhang of the University of Exeter Business School has led a study measuring the performance of US stocks in the first quarter of 2020. In the three weeks between the start of the market decline and the US government’s bail-out package, firms with high ESG ratings outperformed those with low ones by 7.2%.

It seems corporate level ESG policies “are as valuable in creating resilience as cash”, which Professor Zhang described as “extraordinary”. The key may be consumer attitudes: “credible ESG policies tend to attract more loyal customers, [implying] less need to compete on price”.

Building a brand

This sounds credible and reinforces the idea that ESG burnishes brands, which in turn transforms ESG firms into a new form of quality stock – the type of stock that can become overpriced for extensive periods of time.

Analysts at Killik & Co highlight the bigger picture: the regions in China, Italy and the UK worst-afflicted by Covid-19 tend to be areas with high atmospheric road pollution. So climate change and adaptation to a post Covid-19 world become the same concern. More broadly, the push towards a greener, cleaner world will drive the “greatest reallocation of capital of the 21st century”. And of course, gold rushes have a tendency to create their own forward momentum. So if the markets do take another tumble, ESG funds could be a defensive way of playing several trends at once.

I wish I knew what ESG investing was, but I’m too embarrassed to ask

Environmental, social and governance (ESG) investing – and similar approaches such as socially responsible investing (SRI) – aim to make money while avoiding firms viewed as having a negative impact on the world and encouraging those that have a positive impact.

Traditionally, ethical approaches to investing mostly focused on not buying any companies in businesses that the investor dislikes (known as exclusionary screening). This often included vice stocks, such as tobacco, gambling or alcohol. Some investors might aim to invest more in industries that they view as beneficial (such as renewable energy), although this was less common. However, as demand for ethical investing has become greater, this has evolved to include approaches where the investor takes into account whether a firm is trying to follow the highest standards they can within their sector. Hence an oil producer or a miner would not necessarily be ruled out in some funds or portfolios that follow ESG mandates, so long as the firm is attempting to minimise the adverse impacts of what it does. Some ESG investors will also engage with firms to try to pressure them to follow more sustainable practices, rather than simply not investing in them.

Environmental factors are probably the first thing that many investors associate with these kinds of investing strategies – from climate change to air and water pollution to biodiversity. Social issues are perhaps the broadest and the hardest to measure: they can include how the firm deals with customers, labour standards and human rights in its supply chain, or matters of gender, diversity and equal rights in its workforce. Governance is the strand that is most closely associated with traditional investment analysis: it includes issues such as executive pay, fair treatment of minority shareholders and questions of business conduct, such as bribery and corruption.

If you have no strong views on where to invest, a cheap passive fund that tracks the whole market is a sensible place to begin. So to build a global portfolio of equities, the obvious starting point is an index such as the MSCI World and the FTSE World. But when you look at the details of these indices, you might wonder if they accurately reflect where you want to invest.

Take the enormous weighting in US stocks, for example (64% of the MSCI World). Or the absence of any emerging markets (EM) – nothing at all in the MSCI World, which is developed markets (DM) only, and only a small part of the MSCI AC World (China, the largest, is just 4%). You may feel that neither of these are consistent with how the global economy works.

Yesterday’s economy

And you’d be right to question that. The US accounts for around 25% of global GDP, while EMs comprise about half. This is not yet reflected in global market indices, partly because DMs tend to have larger and more liquid stockmarkets: more firms are listed, and the free float (shares that are not owned by governments or other controlling shareholders and are available for investors to buy) is typically much higher. But it is also due to valuations: the US now dominates global indices partly because valuations there are so high.

To get a benchmark more in line with the size of the global economy, we could weight by GDP instead. Would that improve performance? MSCI calculates a GDP-weighted index version of both the MSCI World and the MSCI EM. The EM one has beaten the standard index by 1.7 percentage points per year since 2000. The DM one is still ahead overall since its inception in 1969, but has lagged badly over the last ten years because the US beat other developed markets by a large amount over that time. That may continue – but the example of Japan in the late 1980s (when it briefly accounted for more than 50% of global market capitalisation) suggests it could one day reverse dramatically (see chart above).

GDP weighting wins out

If so, GDP weighting could again be better than market-weighting. There are no broad GDP-weighted ETFs – a fund with such poor performance over the past decade would be tough to launch. But a handful of regional funds would build something similar. For example, with five Vanguard ETFs – FTSE North America (25%), FTSE Developed Europe (25%), FTSE Japan (7.5%), FTSE Emerging Markets (37.5%) and FTSE Developed Asia Pacific ex Japan (5%) – you could get most markets closer to their GDP weights, at a total annual cost of 0.18%.

I once called Terry Smith to have a chat about his global small and medium company investment trust, Smithson, from his asset management firm Fundsmith.

I talked about this a bit here, but I know that an awful lot of MoneyWeek investors are huge Smith fans something that makes sense given the out performance of his flagship Fundsmith Equity fund (up 309% since launch in 2010 against 157% for the MSCI World index), so this is just to update you on a few of the other things we talked about.

I asked him if he was concerned that Fundsmith itself was getting too big to keep outperforming particularly given that he doesn't like to have much more than 30 holdings in it. He is not. With 27 holdings in companies with an average market cap of around £100bn, he says, holding only 1% of each of them would only give him a £27bn portfolio. Plenty of room to run yet.

However, the size of the first fund is a part of the reason behind Smithson. Size, says Smith, "cuts off opportunity". When he launched Fundsmith Equity, for example, he bought Domino's Pizza and was able to let it grow inside the fund. But given the size of Fundsmith today, he couldn't buy the "next Domino's" (something such as, say, Wingstop) as he'd up with one third of the company. And that's too dangerous.

Concern about size also explains the use of the investment trust structure for the new fund. He's after £250m upfront and, if successful, the trust will surely expand, but the closed-end structure does mean that he won't end up with the same size problem (the directors control whether new capital can come into the trust or not).

Who's running Smithson, and what's in it

Smithson isn't going to be run by Smith himself, it will be run by Will Morgan and Simon Barnard. Why them? Lots of money managers come to Smith asking for jobs, he says. All come in saying how much they love his style of investing and how much they want to invest just like him. To all of them he says, "why not do it yourselves?" After all, most of the applicants are already working as fund managers.

Most of the answers to that are about not being allowed to take positions with the kind of conviction Smith can (compliance, compliance, compliance). But Morgan and Barnard added a little something extra to the mix: they told Smith that they had their "entire liquid net-worths in the main fund". We gloss over what their liquid net worths might be (ie, I ask and they won't tell me). But you get the point.

The two were hired and set to work finding the kind of stocks that fit the bill Fundsmith-style. This involved looking for those that had "done better than us"; chucking out the ones that were of no interest (Smith is not mad, for example, for "Canadian cannabis firms); and making a long list of those that were (high quality, good cash flows, low debt).

The final list (which will presumably grow) consists of 83 companies with "growth rates approximately twice that of those in the main fund" although Morgan and Barnard will only hold 25 at a time (they will also be running all final investment decisions past Smith). About half the stocks are listed in the US, with the rest also being in developed markets mostly Europe with a few in Japan, Australia and New Zealand as well. None are in emerging markets (this will prevent cross over with Fundsmith's so far underperforming emerging markets trust).

Smithson won't be cheap but that may not matter

Finally, fees: Smith will charge 0.9% in management fees. I wish this number was lower. I wish it was set to be the lower of net asset value (NAV) and market cap (Smith says he is pretty ambivalent on which it should be but his decision is to charge it on market cap, as this performance is the "closest to what investors will get"). And I wish that Smith would commit to stepping the fee down as the trust grows.

I will have to keep wishing.

Smith doesn't agree with me on the imperative to lower costs for investors and could perfectly reasonably answer any criticism with the point that he doesn't need to. The 1% fee on Fundsmith Equity clearly isn't putting anyone off!

Should you buy into the trust? We don't normally suggest buying at launch as most trusts go to a discount to net asset value fairly quickly and we probably won't be IPO buyers here either (see John's article on why not to buy at IPO). However, if you are huge Smith fan, note that going to an immediate discount is less of a given with anything from Smith: such is his army of fans that his emerging-markets trust trades at a premium despite underperforming.

US stocks are heading for a post-war record. The benchmark S&P 500 index, which sets the tone for the rest of the world, has been in a bull market since March 2009 or just over 3,400 days, as stockbroker AJ Bell points out. It is only 50 days short of the longest post-1945 bull run, October 1990 to March 2000. And having risen by 400%, it has easily eclipsed the 283% average rise of the ten previous post-war bull runs. It may well get through the next three months without slipping by 20% which would constitute a bear market and thus break the record. But then? "The list of headwinds is long and daunting," says Fidelity's Tom Stevenson in The Daily Telegraph.

A sea of troubles

Global stocks have suffered their worst first half since 2010, with the MSCI World Index of developed-country equities slipping by 1.3%; Europe and Japan finished down, while the S&P 500 ticked up. The global economy has lost some momentum, with European and Japanese data proving disappointing of late. This is partly due to the deteriorating outlook for global trade their economies and stockmarkets are more dependent on exports than America's. With Europe this week threatening to retaliate against probable US tariffs on European cars, "we slip, ever more irredeemably", towards an "outright" trade war, says Jeremy Warner in The Sunday Telegraph.

The rise in the oil price to a four-year high is another worry, as it gradually slows global consumption, while in the past few days investors have started to fret about China again. Its stocks have slipped into a bear market and the yuan has fallen sharply. These are "echoes of the plunge in the Chinese market in 2015" when the devalued yuan "threatened to trigger capital flight", says Stevenson. Europe's reappearing euro crisis, meanwhile, is doing nothing to alleviate the increasingly jittery mood in world markets.

Earnings growth is slowing

The economic and earnings backdrop isn't looking too hot, either. The artificial stimulus from the Trump administration's corporate tax cut will fade in the next year or so, with earnings-per-share growth dropping back from 21% in 2018 to 10% in 2019. Valuations are sky-high. And while the US Federal Reserve is only tightening monetary policy very gradually, the prospect of a sharp hike, destabilising markets and indebted corporations, looms over equities. The labour market keeps tightening, with the share of small businesses raising compensation at a 34-year high. "Accelerating pay rates are likely to provide a big surprise in the second half," David Levy of the Jerome Levy Forecasting Centre told Barron's keep a close eye on Friday's labour market data. On the other hand, companies could decide they can't pass on higher labour costs, and absorb them instead, denting their already historically high margins. That won't do earnings any favours either. Whether it ends with a bang or a whimper, the S&P 500's long bull market is starting to run out of puff.

Asset allocation is at least as important as individual share selection. So where should you be putting your money? Here's our monthly take on the major asset classes.

Equities

Finding their feet

Major stockmarkets have steadied after January's plunge: Britain's FTSE 100 has jumped by 11% from its mid-February low. But the fundamentals look lacklustre. Indeed, 2016 earnings estimates for the companies in the developed markets benchmark, the MSCI World index, are 12% below last summer's level. However, gloom over the world economy looks overdone and central-bank money printing is likely to offset trouble on the earnings front, especially if markets are reasonably valued. That means Europe is a buy, while we continue to like Japan. Be careful of America, where interest rates are rising and stocks are historically expensive.

Emerging markets, meanwhile, are starting to look attractive. They are trading at a wider discount to their developed counterparts than at any time in the past decade due to concerns about growth. Yet China could be set for a recovery following several interest-rate cuts and loosened lending criteria. This bodes well for many other Asian economies. Healthier Chinese demand could also help to sustain a recent uptick in commodity prices, benefiting those emerging economies that are major commodity exporters. Our favourite emerging markets include India and Brazil.

Gold

Looking brighter

Gold has had its best start to the year since the 1970s, gaining around 15% as other markets slumped. Investors have flooded back into gold-backed exchange-traded funds after being net sellers of these vehicles for the past three years. The growth scare that fuelled the jump looks set to subside, but keep 5%-10% of your portfolio in gold as insurance against the rapid return of inflation or a fresh financial crisis.

Cash

No move in 2016

Few economists now expect UK interest rates to rise this year, so interest rates on fixed-rate savings accounts have come down again: the average three-year fix is now paying 1.86%, compared to 2.09% six months ago. US rate expectations, which often set the tone for the world, have also been put back since the start of the year, when the market was pencilling in four increases in 2016 after the first move in December. But solid recent economic data has at least stopped talk of a cut, while core inflation has reached a three-year high of 2.2%.

Bonds

Safety first

Japan this week became the first major economy to issue ten-year debt with a negative yield. Government bonds are now so expensive that the value of bonds with yields below zero is now $7trn worldwide. We would consider only safe government bonds that still pay a positive yield (such as the UK and US) and avoid riskier corporate debt altogether.

Commercial property

Slowing down

Average rents across the UK commercial property market grew by 0.2%, the weakest growth for 17 months and a potential sign that the last few years of strong growth in this asset class are over. However, the UK economic outlook remains positive, suggesting that a major reversal is unlikely.

Agriculture

Bearish forecasts

Price of corn, cotton, soybeans and wheat all declined in February after the US Department of Agriculture (USDA) released its preliminary forecasts for production in 2016/2017. The USDA expects solid production figures in corn, cotton and soybeans. Wheat acreage is likely to decline to a multi-decade low, but stocks from last harvest remain abundant. Elsewhere, sugar prices rose after the International Sugar Organisation cut its production forecasts and palm oil prices also rose over expectations that dry weather in Malaysia would lead to disappointing output there.

Energy

Shale production drops

Brent crude oil dropped from $35 per barrel at the beginning of the month to under $30 per barrel, before recovering on further signs that low prices are finally having an impact on the US shale oil and gas industry. The number of rigs operating in America fell to under 500, down by two-thirds since the beginning of 2015, and output from most major shale regions has started to fall. However, a strong rebound in oil prices is unlikely: global supply remains abundant and US shale production can be ramped up quickly if prices were to rise back towards the $50-$60 per barrel level.

Industrial metals

Stabilising

February saw more tentative evidence that a bottom in metals prices could be close. Iron ore led the way, with prices rising 19% as Chinese steel mills began restocking their inventories after the lunar new year holiday. The LMEX index, which tracks the price of aluminium, copper, lead, nickel, tin and zinc, gained 3.5%, with tin and zinc leading the way. Zinc supplies appear to be tightening as producers mothball mines that are no longer economically viable. Tin exports from Indonesia, a key producer, dropped due to shutdowns by smaller refiners and weather-related supply disruptions.

Asset allocation is at least as important as individual share selection. So where should you be putting your money? Here's our monthly take on the major asset classes.

The start of a shake-out

Last month's high-profile meltdown in a US fund that specialised in junk bonds has focused investors' attention on risks in this part of the bond market. In recent years, income seekers have flocked to bonds issued by companies with lower credit ratings in pursuit of higher yields. But as interest rates begin rising and the credit cycle turns, higher defaults are likely to hand heavy losses to unwary buyers.

The yield on the Bank of America Merrill Lynch US High Yield index has risen from 6.3% in April to 9% at the end of December as investors head for the exits (bond yields move inversely to prices). We think this is just the start of a major shake-out. Stick to the safest government debt if you want to hold bonds.

The Fed moves, finally

The US Federal Reserve raised interest rates in December, for the first time in a decade. The Bank of England is likely to take longer to act: markets are not pricing in a hike until the end of 2016 at the earliest. However, interest rates vary widely between banks, from virtually nothing to 6% on some "regular saver" accounts, so shop around for a good rate.

Still heading up

UK commercial property had another good year in 2015, according to the IPD All Property index. The asset class delivered a return of 12.5% in the first 11 months of the year, with 7% coming from capital growth and 5.5% from rental income. Commercial property values are potentially vulnerable to higher interest rates or an economic slowdown, butthe asset class can be a useful addition to a portfolio, since rents would be expected to rise with inflation over the long term.

A mixed year

Japanese and European stocks posted respectable returns last year. The MSCI Japan index was up by 8% in local currency terms, while the MSCI Europe excluding UK was up by 6%. These remain our favoured major markets: both are reasonably valued and their central banks are in easing mode, which should help to support stocks. US stocks are expensive, while the FTSE 100 is skewed by its exposure to energy and natural resources stocks (the FTSE 250 index of mid-caps offers better and more balanced exposure to the UK economy).

Emerging markets, another MoneyWeek favourite, had a dire year. The MSCI Emerging Markets index was down by 12% in sterling terms. Russia was the only major market to post a gain (up 6% in sterling terms), but it's still down 30% since peaking in April. Nonetheless, we continue to recommend that long-term investors hold emerging-market stocks: they are one of the cheapest asset classes and there is immense potential for long-term consumer demand growth in many of these economies.

Low expectations

Gold does best during times of high inflation or crisis. Neither are prevalent right now. So the yellow metal has continued performing poorly in recent weeks: it ended December at $1,060 per oz, down 10% for the year. We recommend allocating a small part of your portfolio (5%-10%) to gold as crisis insurance and because we expect inflation to return in the long term. But otherwise we have low expectations for gold prices in the near term.

Silver could beat gold in 2016

Silver is a metal with a dual role. Like gold, it was historically a monetary metal, as well as being used in jewellery. But it also has a number of industrial uses. So it tends to be more volatile than gold, both upwards and downwards. This was true in 2015: it finished at just under $14 per oz, down 12% for the year. However, if industrial demand remains reasonably robust, silver could outperform gold in 2016, since production cuts are squeezing supplies.

Rising supply meets weak demand

The supply glut in base metals saw prices continue to slide in 2015: the LMEX which tracks the price of copper, aluminium, lead, tin, zinc and nickel on the London Metal Exchange dropped by more than 25%. Lead was the least-bad performer, down just 2%, helped by tight stocks. Meanwhile, iron-ore prices fell by almost 40%, pressured by falling demand from Chinese steelmakers. We think metals prices could be approaching a bottom, but it's too early to turn bullish.