Dan Wiener: Hello, this is Dan Wiener, chairman and co-founder of Adviser Investments, with another of our “Adviser You Can Talk To” podcasts. Today, I’ve got as my guest Brian Mackey. He’s a senior researcher at Adviser Investments and Brian’s also a chartered financial analyst. He’s often called upon for his insights into the markets and investing in general by our clients, by his colleagues, and the press. Today I’m going to talk with him a bit about investing in emerging markets. So Brian, I want to dive right in here. First, can you define what emerging markets are?
Brian Mackey: Yeah, it’s a tough definition really because you’ve got a number of different kind of fuzzy characteristics. MSCI and other index providers will tell you that emerging markets are countries that are just less developed than developed markets. So there is a little bit of a fuzzy line but the way I kind of look at it is it’s countries that are just kind of behind the curve compared to where we are here in the west.
Dan Wiener: And you’re talking about the economies in these markets, not the actual markets themselves.
Brian Mackey: So, yeah, there’s the economy part where how is the economy functioning? Do they have regulations in place? But then there is also the market part as well where are these markets liquid? Are foreign investors able to get access to the stocks? Things like that. So, different index providers will have different definitions, but the way I kind of think about it is countries that have, you know, at least as much political risk as economic risk, which nowadays it feels like we’re all in emerging markets, but—
Dan Wiener: No question. China’s a big part of most emerging market indexes. So, I assume that there are other countries like China that you would put at the top of the list of various emerging markets. What would they be?
Brian Mackey: Yeah, so China’s a huge component. The other ones would be India, Brazil, Argentina is another example that’s frontier to emerging, a lot of countries out there that have different characteristics, Turkey, Russia, lots of different types of countries.
Dan Wiener: So, a lot of these sound like risky markets. Why would investors be interested in them in the first place?
Brian Mackey: Yeah, they are very risky. I mean, emerging markets tend to go through a sell off every one-and-a-half years or so. But I think the plus side of it, and the reason why investors are interested, is the growth part of it. So, I kind of think about emerging markets as investing in the United States in 1900. It was certainly a risky time, but if you had invested there and just held your money for a while you could have made a lot of money, and so I think if you believe that those countries can grow faster, then potentially the companies in those countries can grow their earnings faster and the stock market in those countries should outperform.
Dan Wiener: So we also have an issue of a consumer class that’s being built in the emerging markets that is much smaller but maybe faster growing than the consumer class, say, in a developed country, like the United States.
Brian Mackey: Yup, that’s a good point, and I think China’s a great example of that where the consumer only represents about a third of the economy there, versus two-thirds of the economy here. So consumer spending is a huge source of potential growth there for countries like China and that’s another opportunity there. That kind of rebalancing from just exporting goods to the West, and trying to focus more on selling goods that their own people want to buy is I think a huge opportunity within emerging markets.
Dan Wiener: But we have a lot of fast growing companies in the U.S. I mean, do we really have to go to Argentina or Venezuela or China or Egypt or what have you for fast-growing companies?
Brian Mackey: We don’t have to, but I think there is a benefit to owning a bit of both. I’d never say put all of your money in emerging markets and you know the U.S. is just the 20th century is gone and this isn’t going to be the U.S. century, so just avoid it. I think there’s a lot of opportunities in the U.S., especially on the innovative side and the healthcare and the technology area where we’re providing goods and services that the world needs. But I think there’s also a lot of local businesses in these countries that provide a lot of growth as well. So, there’s a bit of a diversification benefit to not putting all of your money in US stocks, but also getting some growth potential overseas.
Dan Wiener: Now you said, I think you said earlier, that there’s a sell-off in emerging markets every year and a half—
Brian Mackey: Yup.
Dan Wiener: Or two years, so talk to me a little bit about the risk in emerging markets. I mean, flesh that out a bit.
Brian Mackey: Yeah, so I think there’s two types of risk. One is the economic side, where there’s a political scandal in Brazil and the stock market drops 10, 15, 20% in a couple days. There’s a coup in Turkey and there’s, you know, the stock market drops there. That’s one part of the risk that you bear in emerging markets and there’s 24 different countries in the emerging markets index. So there’s a lot of different countries where things could go wrong. There’s also the financial market side. So, investors decide in the West that they want to pull their money and they want to get their money back in U.S. dollars and so any country that was dependent on foreign capital to grow is in trouble, and I think we’ve seen both of those in the past where Turkey is a good example of both where when the dollar got stronger they were in trouble, and then there was a coup a year or two later, and they were in trouble again. So there’s a lot of risk.
Dan Wiener: So you’ve actually hinted at another risk, which is currency risk.
Brian Mackey: Yes.
Dan Wiener: What about currency risk and emerging markets? Brian Mackey: Yeah, so any time you go outside of the U.S., even into the Yen or the Euro, you’re taking on currency risk, when you buy those securities. But I think there’s, it’s probably a bit more acute in emerging markets because the volatility in those currencies tends to be a bit higher.
Dan Wiener: I mean, currency risk works in both directions—
Brian Mackey: Yes, yes.
Dan Wiener: For U.S. investors. Okay. If someone is thinking about investing in emerging markets, I mean, we’ve been talking I think primarily about Emerging-market stocks. If you’re thinking about emerging-market stocks is this something that every investor who’s interested in having a globally diversified portfolio ought to have money in or are there some investors who maybe ought to just say, you know what, emerging markets really aren’t for me?
Brian Mackey: I’d say it’s not for everyone. I think even for equity investors it’s not even for all equity investors. So, to separate that out, first of all you’ve got time horizon, right? You’ve got some people that just can’t take market risk. They can’t stomach losing 50% because they have to spend, you know, a good chunk of it next year.
Dan Wiener: I can’t even stomach losing 50%, but I’ve done it.
Brian Mackey: Yeah, some of us have to. But so there’s, some people just can’t take equity risk and I think once you get to the people that have, you know, at least a three to five year time horizon, hopefully a lot longer than that, even then it’s not always appropriate for even those investors because just the draw-downs are so much larger, can be so much larger, and more frequent than in developed markets. So, I’d say, you know, the most growth-y investors, if you’ve got more than 70% of your money in stocks then I’d consider some emerging market stocks in that 70%.
Dan Wiener: And what kind of emerging market exposure would you have? Maybe we ought to talk a little bit about—
Brian Mackey: Yeah.
Dan Wiener: About your overall foreign exposure, exposure to companies in markets other than the U.S., and then what portion of that you might want to have.
Brian Mackey: Yeah, so the way, so in terms of allocation between developed and foreign, emerging markets represent about 7 or 8% of the global equity market. Now, if you’re a U.S.-based investor, it might, it probably doesn’t make sense to have that much money in emerging markets because you’re taking the additional currency risk, right? So, I’d look at that as sort of the most I would consider, 7 or 8% in emerging markets because of that currency risk. There are times when emerging markets are going to be kind of extremely attractive because you’ve got these big sell-offs every once in a while and maybe you want to go over that. But generally speaking the right amount in emerging markets is probably in the 3 to 5%, maybe 7% or 8% range.
Dan Wiener: And you can get exposure to emerging markets in many diversified foreign stock funds, right?
Brian Mackey: Yes, yeah, so you can buy international, you know, developed funds and you can get exposure in a couple ways. I mean, you can, they will go out and buy emerging-market stocks directly or a lot of times, I mean, the other way that we all get emerging markets exposure if you’re invested in stocks is a lot of times you’re investing in global businesses and those businesses are growing in emerging markets as well. So you’re definitely getting exposure one way or another but there’s a number of ways to do it.
Dan Wiener: All right, let me, let me ask you the thousand dollar question here, which is do we invest in emerging markets? Do you suggest investing in emerging markets through passive vehicles, like index funds and ETFs, or do you really want to get an active manager in there? We know the expenses are going to be a lot higher. With an active manager, because they’ve got to put boots on the ground.
Brian Mackey: Yeah, so, and I think there it really comes down to your ability as an investor. So if you believe that you’ve got the ability to find talented active managers out there there’s tremendous opportunity in emerging markets because there’s a lot of junk in there. There’s a lot of state-owned companies. There’s a lot of just commodity exporters that are just kind of dependent on the price of commodities. So there’s a lot of companies out there that you can avoid if you can find a talented active manager that can put that money into something else that can do better. If you don’t, if you don’t have that conviction, I still think you can invest in emerging markets. Just go by the index. Keep it cheap, and you’ll still do well. But you have to recognize that you’re going to get a lot of cyclicality there. There’s going to be much more ups and downs especially if you’re investing in the index versus, you know, a more risk-controlled type of active manager.
Dan Wiener: And if you were investing in an index, not being an expert in the area, if you were investing in the index versus an active fund, would you maybe suggest that you have a smaller portion of your portfolio in the emerging markets, because you’re taking on all of that, you know, the cats-and-dogs kind of risk in the portfolio?
Brian Mackey: Yes and no. I’d say if you, if you’re investing, if you’re comparing an index to an active manager and the active manager is taking just as much risk then you probably should have the same allocation no matter what. But I think if you’re investing with a manager that has a much more risk-controlled process, in that case I think you could probably up the bet so to speak in emerging markets with that active fund.
Dan Wiener: All right let’s end this by asking the question is this a good time to put money in emerging markets?
Brian Mackey: That’s a tough one to answer. I’d say, I think if you’ve got that five-plus year time horizon, yeah, I think, you know, the forward PE ratio, so the price to earnings over the next year is going to be, it’s about a 12-times earnings ratio versus 18 for the United States. So, emerging markets have run up here, but I still think they’re an opportunity and I think if you’re a long-term investor and you believe in diversification I think absolutely emerging markets are still a buy even today.
Dan Wiener: Okay, thank you. That was Brian Mackey. He’s a senior researcher at Adviser Investments. Brian is also a chartered financial analyst and this is Dan Wiener, chairman and co-founder of Adviser Investments with another “Adviser You Can Talk To” podcast. Thanks for joining us.