(Reuters) - Institutional investors are being selective in their return to emerging markets after a heavy sell-off, as there are too many pitfalls for a long-term portfolio to make a winning strategy out of simply buying cheap.
More than $50 billion (29.9 billion pounds) flowed out of emerging stock and bond funds in the first quarter of 2014 as rising U.S. yields, China's economic slowdown and political uncertainty drove investors away from higher-risk assets. But the tide appears to have turned.
Emerging stocks .MSCIEF hit their highest level in almost five months on Thursday after four consecutive weeks of rises. Emerging dollar debt has risen more than 5 percent this year, outperforming U.S. Treasuries and global corporate bonds, and even less popular local currency debt managed a rise of 3 percent.
Cheap valuations after months of selling opens up easy trading opportunities for those who can get in and out quickly.
But long-term investors need a strategy that both exploits a short-term rebound and minimises losses from long-term structural economic difficulties such as the higher cost of funding for companies.
"The long-term investment landscape suggests emerging markets will continue to underperform in the long run. A rising rates and strengthening dollar environment is a real headwind," said Andy Warwick, multi-asset portfolio manager at BlackRock.
"In the short term, there are tactical opportunities in emerging markets. We're already starting to see that, looking for value, as stabilisation of U.S. yields has made emerging market carry more attractive."
BlackRock has made a number of long and short trades in Turkish equities - buying and selling in a matter of weeks to capture tactical opportunities.
"It's about being tactical and (finding a way to) capture and embrace volatility. The market needs to get used to what a rising interest rate environment looks like. Rising rates create volatility, and volatility creates opportunities," Warwick said.
In the past two weeks, emerging-market-dedicated equity funds saw $5.4 billion of inflows, according to EPFR, which analyses mutual fund data.
In the week to April 9, the broad Global Emerging Market (GEM) equity funds group attracted the biggest flows at $3.47 billion, in a sign that retail investors are indiscriminately scooping up beaten-down stocks.
"A lot of investors treat EM as a basket case, and they go in and out. But we believe, particularly in EM, investing in the index is a poor choice. The benchmark is skewed towards these companies that may suffer for a little longer," said Enrico Camera, emerging equity fund manager at Swiss-based GAM.
"We don't see profitability in EM. And we struggle to see a bull market in EM in the long term. At the same time, if you are selective, there are a lot of opportunities."
Camera likes the EM consumer discretionary sector, which will benefit from the increasingly wealthy middle class.
He said EM-listed consumer staple companies, on the other hand, were on GAM's list for short selling, as were steel and iron ore-related firms.
In fixed income, dollar and euro-denominated hard currency debt funds grabbed more flows ($0.85 billion) than local currency ones ($0.3 billion), according to EPFR.
Denis Girault, head of emerging market fixed income at Swiss investment manager UBP in Zurich, recommends that investors take advantage of price distortions to buy investment grade EM corporate debt, which is yielding more than junk-rated European corporate bonds.
The latter, rated double-B, are yielding on average 5.2 percent, while higher-quality emerging market corporate debt with a triple-B rating is yielding 6.6 percent.
This gap is a result of huge investor demand for high-yielding debt in developed economies.
"We have today true arbitrage opportunities which have emerged in the last couple of months," Girault said.
"Companies have far more flexibility to adapt. Your best bet is investment grade."