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Financial Times - Why buy Brics when you can have Mugs?

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Perhaps the most dangerous investment concept is the “no brainer”. Take emerging markets equities as an example. They should surely have much better returns than those in developed economies, as they mostly have better demographics with young, fast-growing populations; higher GDP growth; and they didn’t suffer the meltdown from the collapse of their banking systems that plagued the US and Europe.

How to play this theme? Most would buy an actively-managed emerging markets equity fund. If you did so in the past few years you have almost certainly suffered disappointment.

Over the past five years, the average return for the funds in the Investment Management Association’s Global Emerging Markets sector was 65.7 per cent. They underperformed the MSCI Emerging Markets Index, which rose by 69 per cent over the same period.

Nothing new here, you might well think – the average active manager underperforms the benchmark, often owning so many shares that the fund becomes a “closet index tracker”, replicating the performance of the index but with the added drag of fees and dealing costs. Far from being a surprise, underperformance is a near-certainty.

You could avoid it by investing in an index fund instead. Had you bought a fund that tracked the MSCI EM Index you would indeed have fared better over the past few years.

But you would still have done significantly worse than if you had bought a fund that tracks a developed-world benchmark; the FTSE 100 is up by 102 per cent and the S&P 500 by 124 per cent over the same period. Faced with this experience, it must be tempting for investors to conclude that the assumption of superior returns from emerging markets is just plain wrong.

But the peak of disappointment would be if you had bought into one of the most popular themes of emerging market investing over the past decade and put money into a Bric fund. The acronym Bric was coined by Jim O’Neill, then an economist at Goldman Sachs, in 2001 and stands for Brazil, Russia, India and China. It was supposed to identify the four economic powerhouses of the future, and plenty of passive and active products have been constructed and promoted around it.

Surely few EM investments can have performed better than a Bric fund? Wrong again. Over the past five years, the MSCI Bric Index is up just 44 per cent, underperforming both emerging markets generally and developed markets such as the US and UK. Needless to say, the average Bric active fund has also underperformed the Bric Index too.

A big reason for this disappointment lies in what makes up these indices. The largest companies, which dominate the EM Index, are Asian consumer electronics companies, Chinese banks and internet companies, phone companies and Russian energy companies. I would regard all of these companies as uninvestable. In the case of the banks in particular, their risk exposure is opaque. I wouldn’t invest in a bank in the UK, so what would possess anyone to trust the accounts of a Chinese bank? Yet the largest sector by far in the EM Index – representing over a quarter of it – is financials.

The companies that I would regard as most investable are consumer staples. These represent just 8 per cent of the EM Index.

So it is no surprise to me that the EM Index, its tracker funds and the closet trackers among the active funds who secretly track it too have performed badly.

Investing in an index of the Brics is a leap of faith for another reason. The Heritage Foundation, a US think-tank, publishes an annual report using a factor model, which attempts to rank countries in an Index of Economic Freedom.

The index assesses how attractive they are for business and investment based on data on a series of factors including property rights, corruption, size of government, regulation, flexibility of labour and liberality of markets.

Places such as Singapore, Switzerland and Hong Kong rank near the top. The highest-ranked Bric is Brazil at number 114 (out of 186), followed by India at 120, China at 137 and Russia down in 140th position.

If you were willing to invest on the basis of a snappy acronym with no regard for the economic and political characteristics of the countries, perhaps you should have subscribed for a fund investing in a group of countries which each rank a little ahead of the Brics in terms of Economic Freedom. Forget the Mints or the Civets – how about Moldova (110), Uganda (91), Greece (119) and Suriname (130)? These I have christened the Mugs, a pretty good description of anyone who would invest on this basis.

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Terry Smith

Financial Times