Fund manager Q&A: Emerging markets funds

Investors have been betting heavily on emerging markets stocks this year, and the strategy appears to be paying off.

The MSCI Emerging Markets Investment Market Index, which covers securities across developing nations, is up nearly 16 percent this year, according to FactSet. Compare that with the Standard & Poor's 500 index, which is up 7.2 percent.

Fund investors are piling in. Through the first four months of this year, net flows into emerging market U.S. funds totaled $26.17 billion, according to Morningstar. That's an increase of more than 20 percent from the net flows that went into emerging markets funds in all of 2016.

Why such a focus on emerging markets funds?

David Semple, portfolio manager for the VanEck Emerging Markets Fund (GBFAX), points to a couple of factors: Better-than-expected earnings from companies in developing nations and the prospect of higher short-term interest rates, which traditionally has been a precursor to better growth.

"That underpinning in terms of fundamentals is very positive in terms of the ability to sustain what has been a very good rally so far this year," Semple says.

His fund focuses on companies in the developing world with potential for growth at a reasonable price, which often means small-cap stocks. It is up 22.5 percent this year, according to FactSet.

Semple spoke with the AP about where emerging market stocks are headed. Answers have been edited for length and clarity.

Q. Is this a good time to get into investing in emerging market funds?

A: Rather than say this is necessarily a good time, I'll run through four different things people should be looking at.

The first is the dollar. A strongly appreciating dollar is not good for emerging markets. It sucks liquidity out of emerging markets. It reduces earnings and there's a translation effect of what emerging market companies can achieve and how that's translated back to developed market based investors.

The second is rates. The short end of the curve moving up in the U.S. is not something to be feared. Traditionally it's tied to better growth prospects.

The third element is, broadly speaking, politics. We're talking about big structural changes which come as part of the disenfranchisement of lower skilled workers in developed markets in favor of emerging market consumers and middle class, who have seen their incomes go up. But if you see protectionism and trade tariffs actually happening, then that would tend to be a negative for emerging markets. So as the administration's agenda has moved perhaps away from that, then that's positive for emerging markets.

The most important: In the last four or five years, emerging markets companies have disappointed in terms of earnings. That has changed over the last year, where emerging markets companies, on the whole, have produced better earnings than expectations and have certainly lived up to those expectations.

Q. How do you go about selecting companies for the fund?

A: It focuses on companies with structural growth at a reasonable price. By that we mean visible and persistent growth. Which means we steer away from some of the more cyclical elements of emerging markets, like energy or materials. And we tend to invest in companies where we have a high degree of confidence that profitability will be growing on a persistent basis. We have to identify those companies that have that structural growth and then have a strong discipline about not paying too much for them.

Q: What's an example of a company that fits your criteria?

A: Tencent in Hong Kong. It is an internet company that has one of the largest communities after Facebook. Most of their users spend more than an hour a day on their properties. That's a company which optically looks expensive but which we think is justified by the growth of it.

Q: What sets one emerging market fund apart from another?

A: If it walks, talks and looks like the index, there's not really much reason to look past them. But our view very strongly is that the index represents, as it always does, what has happened, not what's going to happen. We would argue strongly that at this juncture what is going to happen or where the success will be in emerging markets looks very different from what the index constituents will tell you to invest in now. So you have to look for a manager that is being active. And it means basically not being beholden to this historic construct of what emerging markets used to be. Because we're changing.