Five high-quality EM funds

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You have to sift emerging markets carefully to find attractive companies

Emerging markets offer plenty of potential, but the standard of listed companies is often poor. Cris Sholto Heaton picks five funds that focus on better-quality businesses.

The great dilemma for investors in emerging markets is that many of these countries offer enormous long-term potential, yet their stockmarkets are often dominated by companies that are fundamentally unattractive. These may be huge state-controlled businesses that put policy ahead of profit, oil, gas and mining firms whose future depends more on commodity prices than the evolution of their economies, banking groups stuffed with bad loans, or sprawling conglomerates run to enrich their founders rather than minority investors. Often they suffer from many of these problems at the same time.

Since these firms dominate their stockmarkets, they also dominate the holdings of exchange-traded funds (ETFs) and other passive funds that simply track benchmark indices. And despite the claim by virtually every emerging-market fund manager that I’ve ever met to be concerned about the quality and governance of the firms that they hold, in practice many of the big emerging-market funds are also heavily invested in these unattractive stocks.

I favour a high-quality approach to investing at all times. There is plenty of research to suggest that good-quality stocks deliver superior long-term returns compared with lesser ones while also exposing you to fewer risks. At a time when the global economic outlook is uncertain, this is especially important.

In our cover story last week Jonathan Compton looked at why Turkey could be set for a crisis in the near future and how this could spread into other emerging markets if investors take fright. I also think this is a substantial risk and even though I hold around 40% of my own portfolio in emerging-market stocks – and intend to keep this unchanged – I strongly favour well-placed businesses that should survive over the long term.

I typically invest directly into emerging-market companies rather than funds. However, there are a small number of funds that follow a quality-first approach and these would be my top picks if I were building my portfolio from funds instead.

First, there are the two established Asia-focused smaller-company investment trusts, Scottish Oriental Smaller Companies (LN: SST) and Aberdeen Asian Smaller Companies (LN: AAS), both of which have strong long-term performance records, but Scottish Oriental – which is managed by First State Stewart – has a greater bias towards high-growth companies.

This is reflected in a high weighting to India, where stocks trade on high valuations but growth remains strong. Aberdeen, which follows a more value-orientated strategy, has a number of holdings in Malaysia, Singapore and Thailand. The two trusts trade on a discount to net asset value (NAV) of -11.5% and -9% respectively.

I’m also keen on a third Asian equity fund, which is newer, smaller and more specialised: the Waverton Southeast Asian Fund (which featured in our Personal View column last issue). The three largest country holdings in this fund are Indonesia, Vietnam and the Philippines, all of which have strong long-term growth prospects. The managers of the fund use a value-orientated investment approach, but favour good-quality companies with decent growth prospects and good governance. The fund has outperformed the regional benchmark by a decent margin since it was set up in 2011 and its country allocation and investment approach should complement the two more established Asian trusts.

For a global emerging-markets fund that has a distinctive strategy, I like Somerset Emerging Markets Dividend Growth. The name may imply that it is an income fund, but its strategy is to invest in firms that should deliver decent dividend growth in the years ahead rather than an high initial yield. The largest holding in the fund is South Korea – where improving corporate governance may lead to firms boosting payments to shareholders in the years ahead – but a good part of the portfolio is in countries such as Hungary and Poland, as well as Brazil, Chile and South Africa.

My final suggestion is the Findlay Park Latin American Fund. It’s hard to find a Latin America fund that avoids resource companies, state-owned firms and other low-quality stocks – this is pretty much the only one I know. It rounds out the list well by reducing the Asian bias in my other tips.