Don’t Let High Volatility Scare You From Emerging Markets

I always find it fascinating that in the world of investment, the lower the price of a particular stock or market, the more it seems to be disliked. There are of course many occasions when this pessimism is justified, but over the 25 plus years of being a professional investor I have found that the peak of pessimism is normally associated with price lows, and as a result substantial gains tend to follow.

Always the Same Story

Equally fascinating is when the bears are pressed to justify why the record low fundamental valuations aren't attractive, the response is normally: "It's different this time". These are the four most expensive words in investment.

The stench of overwhelming pessimism and fear in markets today seems to revolve around China or almost anything emerging, be it bond, currency or equity. Yet it was a very different story five years ago, when a plethora of emerging markets and China funds hit the markets. At SCM we took this as a sign to sell all of our Chinese equity exposure. Since April 2010, the MSCI China Index has returned an underwhelming 2.1 percent per annum and the MSCI Emerging Markets Index has gained a paltry 1.1 percent – with much of the selloff occurring in the last few months.

Recognise the Patterns

It's easy to be sceptical of the precision and magnitude of the official Chinese growth forecasts and of course there are huge risks attached when the infrastructure and credit-led booms subside.

But haven't we been here before? Surely most people know about these worries, and therefore their fears are already priced into these markets' valuations?

In the chart above, you can see the valuation of Chinese stocks via Hong Kong rather than in mainland China – as you can currently buy the identical Chinese share 25 percent cheaper in Hong Kong.

According to current consensus estimates, the MSCI China Index stands on a prospective price to earnings (PE) ratio of just 8.6x in a years' time, falling to 7.7x in 2 years' time with a yield of 3.5 percent rising to 3.8 percent over the same period. Compared to MSCI World equities, these stocks are now at the lowest value since the third quarter of 2003 based on PE ratios and most other valuation measures.

Taking a Closer Look

As one might expect, particularly in the field of emerging market equities where sentiment swings can be even more pronounced than in developed market equities, the best time to invest is normally when investors are nervous. At SCM Direct, we looked at the history of emerging market equity performance and volatility from March 2000 to 15 September 2015, using the JPMorgan Volatility Index. The volatility we see today is not normal, as it has been lower 84 percent of the time since March 2000. The reason we chose this volatility index is that it has a long history and currency emerging market volatility has been a good proxy for emerging market ETF volatility.

When emerging markets are more volatile than usual, which is normally associated with investor pessimism (shown by the yellow line), the future returns are actually strongest (shown by the blue line).

Source: SCM Direct.com; Bloomberg

We looked at the total return (i.e. capital + income) investors would have received over the next 12 months, simply by investing every time emerging markets were as out of favour as they are today (as measured by this index of emerging market volatility). The median return was 24.4 percent. It is worth noting that we used the median rather than average to reduce the impact of the abnormally high returns that followed the 2008 credit crunch.

Three ETF Tips to Invest

As the chart below shows, by investing at times of volatility at or above today's levels, investors have received returns of between 10 percent and 30 percent. To be precise, there were 565 days during the period from March 2000 to September 2014 (we could not look beyond September 2014 in order to calculate the actual next 12m return). When the volatility was the same as it is at the moment, and in every case the following 12 month period gave positive returns.

Source: SCM Direct.com; Bloomberg

In my view, there are three good ways to play this discovery: either via an MSCI China ETF e.g. the HSBC MSCI China UCITS ETF (ticker HMCH) or a well-diversified emerging market ETF e.g. the iShares Core MSCI Emerging Markets IMI UCITS ETF (ticker EMIM), or a broad emerging small cap ETF e.g. SPDR MSCI Emerging Markets Small Cap UCITS ETF (ticker EMSM).

Alan Miller is chief investment officer at asset manager SCM Direct.com