EM portfolios can gain from balance
Investors looking to optimise their exposure to emerging markets should not limit themselves to strategies that focus only on large companies and countries, advises Joseph Mariathasan
At a glance
• The simplest way for investors to get emerging market exposure is through global equity mandates.
• The downside of such strategies is that they tend to focus on large companies and large markets.
• Emerging market indices are in some respects unbalanced.
• China’s imminent inclusion in MSCI indices is likely to catalyse a debate about how best to gain access to emerging markets.
For UTI, a large Indian mutual fund group, 2016 has been a frustrating year. It is true there have been enormous flows into emerging market equities, but UTI’s active Indian equity funds have seen little of that. As Praveen Jagwani, CEO of UTI International explains, most flows have been into global emerging market (GEM) index funds through exchange-traded funds (ETFs). The next largest flow has been to active GEM products followed by, in the case of India, index funds through ETFs. Active funds such as UTI’s India strategies come bottom of the list. This does raise a number of issues for both managers and investors.
The simplest way for institutional investors to acquire emerging market exposure is by including them within global equity mandates, says Richard Dell, global head of Mercer’s Equity Boutique. As emerging markets account for 10-15% of the global indices, active managers could go to as much as a 20% overall weighting, but the exposures would typically be to larger companies in the major countries.
How sophisticated the alternatives are depends on the governance budget of the institution. But Mercer recommends the use of stand-alone global emerging market mandates, rather than going down the route of single country or regional funds. Dell argues that there is more potential for alpha in a global mandate because there are more degrees of freedom and a wider opportunity set. But there is also the problem investing in single-country and regional funds raises the question of how to allocate capital between them to gain a global exposure.
The big downside of GEM fund strategies which Dell does accept, particularly with benchmark-constrained approaches, is that there will be a tendency to concentrate exposure in larger companies and larger countries. Brazil, Russia, India and China together with South Korea, Taiwan, and South Africa dominate most traditional GEM institutional portfolios, yet this leaves a large part of the opportunity set untapped. But if that is the case, are investors really getting exposure to what is perceived as the great tidal wave driving the growth of global output, the rise of the emerging market consumer?
“The emerging market indices are potentially a time bomb” Carlos Hardenberg
One fundamental point that is often missed is that listed equities in many emerging markets can account for much a smaller proportion of the economies than found in developed markets. Adopting a market capitalisation-weighted approach to benchmarks does not reflect the relative size of economies and focuses on larger companies which have historically been more export and commodity oriented.
Moreover, in many markets, many of the listed stocks are so small and illiquid that it makes little sense to differentiate them from private equity investments. For example, private equity firms in India in some cases include listed stocks into their portfolios. along with all the trappings of private equity investment such as board representation and value-added advice.
A key problem with the flows into GEM ETFs is that the main indices themselves, while logical from a consistency viewpoint with a market capitalisation weighting scheme, also look nonsensical from other viewpoints. “The emerging market indices are potentially a time bomb,” says Carlos Hardenberg, manager of the Templeton Emerging Markets Investment Trust. He attributes this to the way they have been constructed and the resulting weighting they suggest as a balanced and optimal way of gaining exposure to what emerging markets are all about. “Once the MSCI index includes China’s A shares and ADRs [American depository receipts], China will move up from 27% to over 50% of the index. If you are an investor trying to get exposure to the emerging markets story, I would describe that as a very unbalanced portfolio.”
The other point that Hardenberg raises is that the sheer size of the GEM ETFs competing in the marketplace to track high-profile indices is leading to market distortions, which does give active managers opportunities. The United Arab Emirates (UAE) and Qatar were added to the emerging market indices with a six-month notice period. This gave hedge funds the opportunity to front-run index funds which had no choice but to add the countries on the day of their inclusion. The performance of countries then lagged afterwards.
At the other extreme of GEM ETFs are single-country active funds for smaller countries. Only the most sophisticated institutional investors tend to invest in these, alongside multi-managers and retail investors. The latter may be sophisticated investors in their own right, or willing to bet on a theme – whether Indian IT, or Gulf economic growth. The main shareholders of Qatar Investment Fund, for example, are US endowments, says the fund’s chairman Nick Wilson. There are only 43 listed stocks and only 23 are investable in size. Banking and financial services make up 43% of the portfolio, representing a proxy for the economy as a whole. Gaining an exposure to Qatar might not be to everyone’s taste, but ignoring it completely because it is too small for a global GEM mandate may also be a mistake.
“Once the MSCI index includes China’s A shares and ADRs [American depository receipts], China will move up from 27% to over 50% of the index. If you are an investor trying to get exposure to the emerging markets story, I would describe that as a very unbalanced portfolio” Carlos Hardenberg
A halfway house between GEM ETFs and the active small country funds are regional and thematic funds. Mercer is prepared to include them but this is driven by client demand rather than its own recommendations, explains Dell. The Duet MENA strategy, for example, focuses on opportunities in Saudi Arabia, UAE, Qatar, Kuwait and Egypt, explains portfolio manager Ali Al Nasser. While 50% of the investors are from the Middle East, the rest include sovereign wealth funds, pension funds and foundations with 30% of their $1bn (€900m) or so from the US, primarily from endowments and outsourced chief investment officers (fiduciary managers) and 20% from two large Scandinavian institutions.
Emerging markets are too large and important to ignore. Yet what is surprising is the lack of debate over how best to gain exposure to the future driving forces behind their growth beyond commodity exports. We are witnessing a historic shift as the emerging and frontier markets, as a whole, evolve into economic powers rivalling the developed markets during this century. These markets are moving from an opportunistic allocation to a core component of institutional portfolios.
While the importance of emerging markets may be accepted in theory, in practice allocations have become less than optimal. Invariably, investments tend to be couched in a framework based on market capitalisation-weighted indices which are leading to increasingly concentrated exposures. The high volatility associated with emerging markets equities is, to large measure, a result of the concentration of countries (seven) and sectors (export-oriented) in the MSCI EM index. With different approaches to investment in emerging markets, it should be able to produce less volatile allocations which are paramount to the preservation of capital.
What will soon provide a catalyst to the debate will be the impact of the huge weighting that China will have on the MSCI index and the problems that will bring. As Dell says, one solution would be to take China and possibly India out and start looking at them in isolation. But perhaps investors seeking exposures to emerging markets, should move away altogether from GEM equity benchmarks and decide what exactly exposure to emerging markets could and should represent. There are far more opportunities in emerging markets than the universe represented by GEM ETFs. What is also worth considering is that it should be possible to produce portfolios that are less volatile.