Undertaking due diligence in the Asia-Pacific region can have the attraction of combining business with great beaches, the lure of the orient and the opportunity to experience the Australian lifestyle. While some investment professionals are honest enough to admit this has influenced their choice of specialism, does it make sense to include a diverse set of countries covering emerging, semi-developed and essentially western economies within one mandate?
A key issue for a regional fund manager is whether they need to focus on countries or on sectors in their investment philosophy. In the management of equities in developed markets, the focus is very much on looking at sectors as country teams are reorganised into global sector groups. Emerging markets however, are characterised by having very strong correlations to local country indices. Managing a mandate that has comparable weightings in both developed and emerging markets can leave managers in a dilemma.
Tom Goodwin and his colleagues at Russell Investment Group have evaluated the changing relative importance of country versus sector in the region. Two key events in the region had to be taken into consideration. Firstly, there was the Asian Crisis from May 1997 to the end of 1998, when there were massive currency devaluations triggered off by speculative attacks on the Thai Baht in May 1997, which caused its devaluation and, combined with macro-economic imbalances and weaknesses within the corporate and financial sectors in neighbouring countries, fuelled contagion throughout the region. Secondly, there was the internet bubble, which swept Asia’s technology-oriented economies along until it burst in the second half of 2000.
During these periods of intense volatility, country and sectors contributed equally to equity market returns. Russell found that Pacific ex-Japan managers “seem to be evolving into more of a matrix approach – their attempt to add some sector watching to the former country watching approach”. This is in contrast to European managers who are seen as scrambling to “re-vamp their top-down country investment models into top-down sector investment models”. The net result of this, according to Russell, is managers of the asset class predominantly implementing a bottom-up-oriented investment process. However, they say, given that 40% of excess returns are explained by country and sector effects, managers are wise to keep an eye on both.
While the region includes many clearly still developing economies alongside Australia, Stuart Parks head of Invesco’s UK-based Asian equities team argues that “many markets are now behaving much more like developed markets than they have in the past. For example, Hong Kong and Singapore are genuinely developed markets with higher GDPs per head than much of the developed world. More interestingly, Taiwan and Korea, historically classified as emerging markets, are now behaving increasingly like developed markets. For example, in economic terms Korea is plainly not performing very well yet the stock market is actually going up which wouldn’t have happened in the past. So markets have effectively discounted the slowdown in exports rather than just waiting for it to occur and then selling off. We saw the sell off much earlier than we would have in the past.”
For managers such as Martin Currie who see themselves as pure stock pickers, having the diverse range of countries within a wide Asia-Pacific mandate gives a broader and deeper pool of stocks to look at. As Richard Evans from their Asia-Pacific team argues: “There are some really good diversifiers in terms of liquid blue chips which we can pick up in the developed markets. These have very different drivers to the GEM market so you can balance off for example, the very heavy export focused markets like Korea and Taiwan with some very good banking and retail models in Australia.”
While a number of the index providers cover the region, the dominant indices are the MSCI series with several sub-indices and choices over which countries to exclude. What to include and exclude is a moveable feast. Clearly, Japan is in a separate class to the rest of the countries in the region through its sheer size, but some, for example Russell, are now moving to an Asia-Pacific ex-Japan index that includes India for their multi-manager funds, now that India’s market capitalisation has grown to a little over 5% of the region.
Given that there is considerable choice in the composition of a benchmark, how sensible is it to suggest that managers hug an essentially artificial combination of weightings? This is the perennial question that is driving an increase in absolute return mandates and leading to a re-evaluation of the strengths and weaknesses of different classes of managers. Invesco, for example, has a retail team in the UK with an absolute return-oriented philosophy. Stuart Parks, formerly the retail manager Perpetual, which was acquired by Invesco to form the core of their European operations, has found that “in the past this type of investment process has not always sat well with institutions but now these institutional clients are coming to us and we have been happy to oblige”.
Using tracking errors to control risk has to be approached with great caution. As Evans points out: “The problem at the moment is that the predicted tracking error is distorted by the fact that volatility has been running at such low levels in a historical context. We have had relatively low volatility in Asia for the past couple of years, and you have to be conscious that tracking error is only as good an indicator of real risk as the historical data going into the calculation. For instance, we are currently running a tracking error at the bottom end of our target range, but feel that the normalised tracking error is probably higher than this. It’s often not until markets fall sharply that returns begin to correlate more highly and reflect the ‘real’ risk in portfolios.”
Parks has also found that: “We are as far away from the index as at any time over the last few years yet, as a result of a lack of volatility the tracking error has appeared to disappear. I would expect that if volatility did recover the tracking error would move out automatically.”
The great attraction of the Asia-Pacific region in the long term is the view, as Eric Huizing from the Ahold Pension scheme in the Netherlands says: “The Pacific region will be the main engine for economic growth. The developments in technology are in Japan and in Asia.”
The traditional boom and bust of the region has declined and as Parks points out: “Increasingly the way to make money in Asia is at the stock level. You are getting a much more measured use of capital occurring. In the past, when a Korean company had free cash flow it spent it on increasing capacity, but now quite a lot of that capital is paid out in dividends in the same way as would occur in developed markets. This has reduced the cyclicality of the market meaning you don’t get as many booms and busts.”
Hugh Young, the managing director of Aberdeen Asset Management Asia, adds: “A lot of work has been done to restructure balance sheets, reduce debt and focus on core skills. Companies are not about to undo this. Surplus cash is being paid out and dividend yields have improved even as markets have risen.”
The growth of domestic demand in the region, reducing the dependence on exports, is a factor in minimsing the risks of the boom and bust cycle. As Evans enthuses: “Now we have Korea and Taiwan earning $12-13,000 (e9667-10,465) GDP per capita, increased property ownership and retail market growth and on the back of that, a broadening equity market. So it is no longer quite the warrant on the export market that you would have expected. At the corporate level there has been a focus on returns rather than ‘growth at all costs’. So I think that the big risk factors which caused the crazy swings in returns in the past have to a large degree been dealt with. Companies today are much healthier than they were.”
Despite the growth of domestic demand, the main risks to the marketplace are still the extent of US and European demand. As Russell finds with their managers: “The consensus opinion in the short term is caution.” Park sees that global growth will slow over the next couple of years as the US interest rate hikes assert themselves, but he points out that China is an increasingly important source of demand for the whole of Asia which means a future of “still acceptable growth for the Asian region but not as fast as over the last couple of years”. Young also echoes this view: “Economic growth is likely to ease off in Asia this year, with an average of around 5-6% expected in Asia ex-Japan, although growth in Japan is still projected to be sluggish at 1%. While valuations are not as cheap as they were, corporate balance sheets are generally strong and corporate governance has improved. We are expecting reasonable earnings growth this year, backed by decent dividends and rising cash flow.”
Where does Australia fit into the Asia-Pacific story? Parks sees Australia as driven by the two dominant sectors of banking and resources covering 60% of the market, with banks “priced for perfection with very few provisions” and with commodity price rises likely to slow as demand and supply move back into line. “The market is on 14x earnings overall and that is a bit of a problem. In Asia markets are only on 11x earnings with a dividend yield of 3%. We feel there are sufficient companies in Asia which are able to tap into headline economic growth and turn it into profitable earnings growth, which is why we are underweight in Australia.”
The sector versus country debate for Asia-Pacific mandates can of course, be made irrelevant by using an index approach, or a quantitatively driven active process that stays close to the indices. Some firms, such as Axa Rosenberg, have even tackled small cap Pacific ex-Japan mandates on this basis. However, Christophe Caspar, responsible for Russell’s multi-manager products covering the region, has the view that “given the inefficiencies of the market, managers with a qualitative process tend to do best. There is clearly a case for researching companies and meeting management and extracting information from companies which aren’t geared to investor relations. Managers close to the companies tend to have a good feel; they tend to have an information advantage.”
Russell has a core group of four managers in their product; Schroders, which has a large team in Asia, mainly bottom-up with a thematic overlay. Russell believes they are well placed to play in the mid and large cap names in the region. “They have a GARP style so are reasonably growth orientated, medium risk and don’t take large country bets”; Lloyd George, a much higher tracking error manager, based in Hong Kong and Singapore and owned by its employees. It has a style more focused on absolute returns regardless of whether stocks are in the benchmark or not. “It is an Asian and emerging market specialist, a kind of boutique, very focused, very high risk.” APS, another boutique also based in Singapore, is fully focused on Asia and very much absolute return driven. “They focus on under researched companies playing the structural secular growth story of Asia.” Finally, BEM is a specialist boutique focused on Australian stocks.
Russell has added an Australian specialist because Caspar says: “Fund managers systematically underweight Australia. If you take a pan-regional manager who has ability to invest within Asia and Australia you end up almost structurally underweight in Australia. One reason is the perception that Australia grows less fast than Asia, which it probably does at the margin but the risk is lower; there are companies which are more transparent than those in Asia with much better corporate governance.
The second reason for an Australia specialist is that most Asian specialists don’t devote much resource to Australia, they think, ‘Let’s do a little research on Australia because certain clients want it’. Frankly there are very few teams who have a good knowledge of Australia.” Invesco would like to see themselves in that category as Parks explains. “The way we are getting alpha at the moment is to go into some of the mid-cap stocks in Australia which don’t look overvalued. We have a slightly defensive bias within the portfolio construction, so we have, for example, a toll road operator and a pharmaceuticals company. The search for alpha has actually lead us to some fairly specialised areas.”
Active managers generally strongly support Caspar’s view of the importance of company visits. Currie sees it as the most important element of their process, with each of their teams monitoring 40 or 50 companies. They combine this with early stage filters of liquidity and a quantitative analysis whose broad factors are quality, value, growth and change. They “primarily look for changes in companies which are defined as, for example, a balance sheet change or a management change which can drive earnings growth. There are two basic change factors in our model – earnings momentum and price momentum.” Currie see both factors as powerful indicators of stock performance over the medium to long term.
Managers tend to be pragmatic when it comes to style. As Evans says of Currie’s experience: “It is difficult to make money consistently with a full on value or growth style because there will be long periods of outperformance or underperformance. If you can run a reasonably pragmatic style I think it helps the risk/return profile of the product.”
Parks echoes this view: “We are very much style neutral. We believe that there are times when it is right to be a growth manager in Asia and times to be a value manager. If you stick to just one label I think that you are likely to be carted out at some point. At the moment we are GARP, but that is more because global economies seem to be stabilising at the moment, so we need to be looking at the individual named stocks rather than making big calls about overall economic conditions.”
Clearly, the Asia-Pacific region is increasingly seen as a key driving force behind global GDP growth. The issue for scheme sponsors looking to invest in the region is, which benchmarks should they use? India and China form a relatively small part of the current index weighting yet they are the true emerging economies of our age. Australia on the other hand, accounts for a huge 30% of the MSCI index, is a developed western economy and may often be considered merely as an ‘add on’ in research terms by Asian regional specialists.