Emerging Market Equities: Emerging questions
The days of a simple emerging market allocation are over. Correspondingly, Joseph Mariathasan finds a variety of approaches among the top performing managers
Emerging market equities are the elephant in the room for any institutional investor - they ignore them at their peril. The importance of emerging markets has increased immeasurably since the crisis, indeed, it could be argued that a seismic change is occuring in the structure of the global economy to the benefit of emerging markets.
“We’ve long held a view that emerging markets can decouple economically - the ability to source economic growth from activities such as consumption and infrastructure spending,” declares Patricia Perez-Coutts, emerging markets portfolio manager at AGF Investments Inc in Ontario, Canada. “As a result, we are optimistic regarding the internal growth drivers in many emerging market countries, and this bodes well for the companies in which we invest.”
This view has also been reflected in the attitudes of institutional investors. “Pre-crash inflows for emerging markets equities were predominantly from retail investors from Asia and Europe investing into BRIC funds,” says Allan Conway, head of emerging markets equities at Schroders. “Post-crash, retail investment has been flat, but there has been significant institutional investment from North America, the Middle East and Australia.”
Emerging markets equities have moved from being an opportunistic asset class, suitable for shorter-term tactical allocation, to a strategic allocation for an institutional fund that may justify weightings above even the 14% or so seen in the MSCI World index.
Unsurprisingly, there have been record inflows into global emerging market equities fund managers with good track records. Conway points out that Emerging Portfolio Fund Reserch (EPFR) data for 2009 which shows record flows of $83bn (€62.6bn) into emerging market funds was likely to be beaten in 2010, with the figure for last year already at $80bn by mid-November. Many firms have ‘soft closed’ their funds to new customers. Aberdeen Asset Management, for example, did this in September 2009, according to its head of emerging markets equities Devan Kaloo (although existing clients can still increase allocations).
This raises a number of issues for investors around gaining exposure if they do not already have a relationship with a fund manager with spare capacity. Conway argues that they have three choices: find one of the strong managers still open to new business; move into ETFs and take a passive approach, even though the inefficiencies and illiquidity of emerging markets would suggest that active approaches can add value; or choose a manager open to business with a poorer record but which shows signs of future improvement.
There are further variations on these approaches: for example, Old Square Capital runs a multi-manager global portfolio described as a completion portfolio, specialising in single country and regional managers investing in smaller stocks that global managers would not have resources to research properly. Combining such a portfolio with BRIC ETFs could be a worthwhile route to explore.
Emerging market equities are probably the most complex of all equity mandates to consider because of the heterogeneous nature of the investment universe combined with an essentially arbitrary set of restrictions imposed by benchmark indices. Not surprisingly, some managers such as AGF declare themselves benchmark agnostic. But as Perez-Coutts points out, even restricting the investment universe, as they do, to 25 emerging and developing economies plus Hong Kong and Singapore, results in more than 5,000 listed companies in the broader indices.
Yet all the global approaches can be summarised as falling into one of three categories: a purely bottom-up stockpicking philosophy that avoids active attempts at generating outperformance through country selection; active approaches that explicitly give weight to top-down allocations; and passive approaches that do not seek to outperform an index benchmark but instead try to minimise the costs of gaining emerging market exposure.
Many firms such as AGF are pure stockpickers. “Country exposure is a by-product of fundamental research,” declares Perez-Coutts. “[But] our security selection process guides us to South Africa, Turkey and Taiwan.”
Aberdeen’s is another good example of a pure stockpicking philosophy that has had considerable success. Moreover, with a highly concentrated portfolio of 45 names and a buy-and-hold strategy with an average holding period of more than five years, the index benchmark is pretty irrelevant.
“The key to the strategy is to focus on the quality of the companies,” explains Kaloo. “The process is geared towards managing the stock selection process so that we do not buy poor quality companies and do not pay too much for good quality companies.” The global product has $27bn (€20.4bn) under management, and builds on the research undertaken by more than 30 analysts based in London, Singapore and satellite offices spread throughout the emerging markets. It focuses on the universe of 800-900 stocks in the MSCI benchmark together with the 1,200 or so in the MSCI smaller companies emerging markets universe.
Aberdeen’s approach encompasses a wide range of regional strategies and the analysts and fund managers working on these that provide the stock selection ideas for the global product. The only recognition of macro-economic factors is that exposures to perceived high-risk countries are controlled - so good companies in bad countries may have their allocations constrained. The approach to stock selection is a traditional mix of company visits, desk research and modelling.
The key theme driving the strategy is clear - the growth of domestic demand. “We have had a skew towards domestic companies for over decade,” explains Kaloo. “The rise of the middle classes and the growth of domestic consumption is less cyclical than export-oriented growth. Moreover, we can find better quality companies in the domestic sector.”
A favourite type of stock is supermarket chains, as they have the ability to defend their margins. The opposite is true of hardware manufacturers, for example, who are squeezed on all sides with global customers such as Dell which demands continual cost cutting. Indeed, the South African supermarket chain Massmart is seen as such a good investment for Aberdeen that they own 25% of the company and have had a blocking vote with regard to the $4bn bid by Wal-Mart for the company. As a result, Wal-Mart is likely to take a controlling stake while leaving the company listed, enabling public investors to continue to participate in the upside.
As at AGF, Aberdeen’s geographic biases - in this case a large overweight position in Mexico, overweight positions in Turkey, Russia and South Africa and an underweight in China - arise purely out of stock selection. This is the case at most emerging market equity funds, argues Conway at Schroders, whose strategy is balanced with a 50% tilt to country-selection. As Conway puts it, why ignore this source of alpha when 50-70% of historical returns can be attributed to it? Indeed, one of the distinguishing features of emerging markets had always been that stocks were more correlated with their domestic index than with their global sector.
Exploiting this requires a country model that can consistently identify outperforming countries. Schroders’ model was introduced by Conway when he joined from WestLB, and like many quantitative country selection models it uses a variety of macro-economic and financial data to produce rankings. This gives rise to weightings that are dramatically different from AGF and Aberdeen with a zero weighting to Mexico and underweight in South Africa, favouring countries such as Korea and Thailand in Asia, Brazil and Peru in Latin America, and Russia, Turkey and Hungary in Europe.
Stock selection is then based on fundamental research combining company visits with DCF-based modelling, resulting in a portfolio of 120-130 stocks. “How much risk we should take [against the benchmark] obviously depends on the return objective,” Conway reasons. “We found that if you can beat the index by 3.5% per annum over a rolling three-year period, you will be in the top half of the peer group 93% of the time, and never in the bottom quartile. That has been our objective.”
The overall tracking error needs to be 4.5-5% to achieve this; it is then disaggregated to individual country limits, which can be as high as 8%. This risk budgeting philosophy also goes down to the level of individual fund managers, using what Conway calls “alpha adjusted tracking error”.
All fund managers underperform at some time during their careers - the question is, by how much and for how long. “We look at weekly performance and if underperformance persists for a couple of months, we would reduce the allowable tracking error; and if it continues, we would reduce it further,” Conway explains. “It may take six months to go from 8% to 3%.” The other key element of Schroders’ risk control is to have a clear stop-loss discipline such that managers have to sell stock once it underperforms by 15%.
Rather than seeking to outperform arbitrary index benchmarks, the other alternative is to be passive. The obvious route is through ETFs, although minimising tracking error against an arbitrary index in emerging markets with poor liquidity can be an expensive way of gaining exposure, if regular rebalancing has to take place to keep tracking errors low. Dimensional fund adviser’s approach of filtering the marketplace to identify the universe of stocks and using a sophisticated trading approach to buy them without reference to an external index benchmark has advantages in not being artificially forced to trade to match an index, while giving market exposure with over 3,000 stocks in the portfolio, but with an annualised turnover of just 6% (as at end-October 2010).
Are global mandates still sensible given the heterogeneous nature of emerging markets, both in terms of their geography and of their development? At what stage should the current emerging market universe be broken down by institutions to consider countries such as China and India as worthy of their own strategic allocations - alongside Japan, for example?
Frontier markets are where emerging markets used to be in terms of perceptions of risk, liquidity and opportunity. The development of specialist frontier strategies and frontier benchmarks is a reflection of this. As Kaloo points out, there are two types of frontier fund management companies: dedicated stockpickers, which are often focused on Asia and Africa; and beta momentum players investing in the larger, more liquid markets (such as the Gulf region). As a result, they tend to have larger amounts of assets under management than the second category, whose holdings tend to be very illiquid and whose funds are capacity constrained.
Investors seeking frontier market exposure therefore need to decide whether they are looking for a short-term tactical play, in which case the first category would be more suitable, or a long-term strategic investment, which would favour the second category of managers.
Mainstream emerging market equities as an asset class is arguably far too coarse a gradation to encompass the range of countries available. The importance of markets such as China and India is so great that it is becoming absurd to lump them with 30 or more other countries with whom they have little in common. Major markets within the universe each pose their own fundamental questions. With its rapidly ageing population, China’s economic growth may stall within the foreseeable future: will China grow old before it grows rich? In contrast, India has a younger population, yet its economic growth is still limited by poor infrastructure: how long will it take to match the growth of China?
Another option for investors is to place more emphasis on regional and single country strategies. Adopting an approach based around the MSCI or S&P/IFC indices produces portfolios that are likely to be more volatile than they need be in absolute terms, and also misses out on countries that are not included in the indices. Moreover, with the top 100 companies in the indices accounting for 50% of the market capitalisation, the typical global emerging market equity fund is heavily weighted towards the BRICs, South Korea and Taiwan - which many would not consider emerging markets at all - and also to the large-cap companies within these countries that dominate the indices. These companies are also less reflective of the domestic economy and tend to be dominated by the financial and commodity sectors. In Russia, 70% of the stock market is commodities yet these account for only 30% of GDP.
Multi-manager approaches to emerging markets can have many attractions both in terms of finding equity managers with in-depth local expertise that are able to tap second tier local stocks, and also through strategies that cover a number of asset classes.
Tapping emerging market growth can also be done via private equity, sovereign and corporate debt, and infrastructure; the relative attractions of each can swing wildly with market gyrations driven by foreign investment. Rather than including China or India within a global emerging market equity mandate, with Chinese property in a property fund, and so on, perhaps a better route would be to recognise that a country accounting for one-sixth of the human population deserves a strategic allocation within any portfolio, but that the best way of gaining exposure may vary tactically with time, perhaps giving rise at some point to a multi-asset China portfolio.
Finally, the size of an optimal emerging markets exposure remains a key decision for investors, largely dependent on whether they regard it as a strategic or tactical asset class.
“Emerging markets account for 65%-70% of global GDP growth,” says Conway. “I suspect the current boom will end up as a bubble, but the price earnings ratio on a prospective basis is still just at 11 and it may go up to 17.” He argues that institutional investors should have a strategic overweight position to emerging market equities even if tactically they may be underweight at any time.
That view is likely to become increasingly prevalent.