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March 19, 2013

Why Emerging Markets? Growth, Demographics and Yield

They’re a study in contrasts when compared to developed markets, says Carlson of Balasa Dinverno Foltz

Chad Carlson of Balasa Dinverno VoltzWhile diversification was the first thing that steered the wealth management firm Balasa Dinverno Foltz to international investing, according to Chad Carlson, there are plenty of other reasons to look to other countries for investing opportunities, both in bonds and in stocks.

Both Carlson and Itasca, IL-based Balasa Dinverno Foltz have “been around the block on international investing.” Balasa has looked abroad for opportunities since 1986, and Carlson's experience in the sector spans a decade. A third of the firm’s portfolios are targeted toward foreign holdings, he said, “with a purposeful overweight to emerging markets.”

Regarding bonds, “we have recently chosen to increase our international positioning to get exposure to different interest rate environments in order to help us navigate the changing bond market dynamics,” he said.

What’s so attractive about emerging markets? They’re a study in contrasts when compared to developed markets. “The developed world—the U.S., Europe, Japan—are struggling to find some growth,” said Carlson. Emerging markets may log growth of 4% to 5%, whereas developed markets are lucky at present to grow by 1% to 2%.

Another reason is demographics. “The developed market demographics are of an aging market,” Carlson said, which is “scary.” Emerging markets are “working-age markets,” versus “retired” markets. “Emerging markets have a lot more going for them, and don’t have the burdens of Social Security and Medicare in place to slow growth,” he said.

“We look at all that stuff, but how we chose to implement [our investment strategy] is through broader baskets of diversified products,” Carlson said. He singles out Mexico as having “a lot of good things going on there,” although he concedes that “emerging markets and frontier markets are pretty risky to pick; there are political [hazards], governments get overthrown, and there are less strict reporting requirements for companies.”

The firm uses index funds and ETFs to take advantage of equity opportunities, as well as an emerging-markets local bond fund that looks likely to provide some currency appreciation opportunities as well. “Emerging market currencies look cheap compared to developed,” he said.

And exposure to currency is what the firm is looking for. “From our perspective on the stock side, being unhedged has made a lot of sense," Carlson said. "In particular, in emerging markets, you want to be unhedged because of opportunities in currency appreciation.”

Another lure of international debt exposure is that “the Canadas, the Australias have better balance sheets than the U.S.; they don’t look as risky for the amount of debt,” according to Carlson. “We have exposure with those, so that if rates go up on bonds and there’s trouble [within the U.S.], we are pretty sure that they won’t go up globally in sync. Maybe other countries will go up a few years after the U.S.; rates will rise at some point,” he said.

With a third of the firm’s stocks in foreign holdings, and about 20% of its bonds also tied to foreign markets, the firm is satisfied with how things are going. Carlson said that the emerging-markets local bond fund is up almost 16%.

Sectors that the firm favors include last year’s investments in foreign real estate, something that’s gone down quite a bit, said Carlson, adding that it definitely rallied back very strongly across the board returning approximately 33%. There was “very, very strong performance with an international REIT; this year, it’s actually reversing a bit. We added that type of exposure [because] we didn’t want U.S. exposure but wanted real estate for diversification,” he said.

Another sector that seems to make sense long term is the consumer sector. Growing populations that are earning more money buy cars, move into urban areas—emerging market indexes are small and focus on the consumer. In the U.S. the sector makes up 70% of the economy; in China it’s 11% of the economy, he said. “If China moves anywhere toward the U.S., there will be tremendous benefit [in that sector] and funds that look for consumer [sector exposure] are an interesting piece to look for growth,” Carlson said.

While currently the firm’s international exposure hovers at approximately a third, its international investing is going to grow. “It will probably be moving up to 40%; it’s just a matter of time till we do that,” he said.

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