Virtus Fund Avoids 'Blow-Ups' in Emerging Markets

(Editor's note: TheStreet today named 82 mutual funds and exchange traded funds, or ETFs, winners and runners-up in its second annual awards ceremony. A list of the funds and related articles can be found on the awards page.)

NEW YORK (TheStreet) -- It may be surprising to hear an emerging markets fund manager say "you're better off investing in the S&P 500 Index."

Rajiv Jain said just that.

Rajiv Jain

Jain has been managing the Virtus Emerging Markets Opportunities Fund (HEMZX) since 2006, during which time it has grown from a couple of hundred million to $3.1 billion in assets.

The fund won TheStreet's Best Funds 2012 award for the equity emerging markets category, followed by runner-up Aberdeen Emerging Markets.

Jain says money managers tout emerging economies -- China, Brazil, India, et al. -- as the best investments. But he views it differently.

"We're not making a call on whether emerging markets will do well," says Jain, who advises that investing in emerging markets as a whole isn't a smart strategy.

What is good, he says, is buying "domestic consumption." To take advantage of double-digit beer-volume growth in China, invest in Tsingtao Brewery, he says. For chocolates and confectionary delights in India, buy Nestle India. And to cash in on soda and fast-food consumption in those same two countries, pick Coca-Cola (KO) and McDonald's (MCD).

In other words, don't buy companies based on where they're located. Samsung Electronics, for example, reflects a lot more than growth in South Korea. The company is the top holding in the iShares MSCI Emerging Markets Index (EEM) exchanged traded fund, which tracks the benchmark index. Yet, as a large provider of Android smartphones, Samsung Electronics takes a big hit when demand in developed countries plunges, as was the case in the fourth quarter, when the company missed analysts' forecasts.

Jain's fund leaves out Samsung along with other top names in the MSCI Emerging Market Index. While many emerging markets funds are "benchmark constrained," Virtus' fund is "benchmark agnostic," explains Jain.

The Virtus Emerging Markets Opportunities Fund contains fewer than 60 companies, which in total derive 90% of their earnings from domestic consumption. Top-10 holdings in Virtus' emerging markets fund include Brazil-based Companhia de Bebidas das Americas (ABV), known as Ambev; British American Tobacco (BTI), which operates factories in almost 40 countries; and Indian conglomerate ITC Limited, whose businesses range from packaged foods to packaging and agricultural exports. China's Baidu.com (BIDU), often compared to global search giant Google, also is a top position.

These companies, Jain says, can "weather a storm," and don't have corporate governance problems that mire some emerging markets firms. The idea is to invest in emerging markets but to limit risk, he says. Virtus' fund has a beta of 0.67, indicating less volatility than the broader index.

A quarterly commentary from Virtus says the fund tends to have fewer "blow-ups" in the event of a large drop in the broader market. The firm takes India as an example, one of the worst performers last year due to high inflation, a weak rupee, government corruption and a lack of clarity in regulation. The three Indian consumer companies in the Virtus Emerging Markets Opportunities Fund -- ITC, Nestle India and Hindustan Unilever -- have "well-established procurement and distribution systems."

"It's not a matter of liking emerging markets or not," says Jain, who also runs an international equities portfolio, called the Virtus Foreign Opportunities Fund. "Emerging markets have always been volatile," he says, so the goal has been to concentrate investments in a few quality companies.

Even before the U.S. financial meltdown in 2008, Jain says his team began to question whether China could keep pace with years of rapid growth. The team began to position itself with the assumption that Chinese construction activity would slow. "Local provinces are massively stretched, iron ore demand will be much slower. The best of the commodity story is behind us," he says. Nevertheless, there are opportunities even in this kind of environment.

Even in sectors that aren't shining, Virtus has made substantial bets on a few stocks. Jain notes that HDFC Bank and Housing Development Finance Corp., two financial-services companies in India, make up 10% of the emerging markets fund's portfolio and account for more than half of its financial allocation. Second to consumer staples, which make up 44% of the portfolio, financial stocks get 17% of the pie.

"While the banks we own are not immune, their underwriting standards are higher than those of the industry," the firm writes. "They have sufficient loan loss reserves on their balance sheet to offset their expected losses as this should be a normal cyclical downturn."

As for how his fund is performing, Jain says investors should evaluate the returns from a three- to four-year perspective. The fund's goal is to "compound at a reasonable rate" with a horizon of up to five years, he says.

Virtus Emerging Markets Opportunities has returned an annual average of 22.4% in the past three years, beating a 20% gain for the benchmark index. It's risen an annual 6.3% in the past five years, compared with the benchmark's 2.4% advance.

The fund underperformed in 2009 when global markets roared back, but outpaced the benchmark in 2010 and 2011.

Jain says his emerging markets fund may underperform in 2012, although not to the same magnitude as three years ago, when profit growth boomed. "Even if growth stabilizes [this year], margins are unlikely to go up from [their current] levels."

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1. To be eligible for consideration, an open-end mutual fund needed at least a three-year history on Dec. 31, 2011, and still be accepting new assets from retail investors; for exchange traded funds, a one-year history.

2. Half of the rating is based on performance metrics, including total return minus expenses, with a weighting to give long-term performance greater emphasis.

3. The other half of the rating is based upon risk metrics, including standard deviation, size of trough-to-peak (drawdown factor), semi-standard deviation and beta. The lower the risk, the better.

4. Top and runner-up funds and ETFs were selected in a variety of categories (funds and ETF were placed in categories via Lipper data).

-- Written by Chao Deng in New York.

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