Applying rocket science to EMs
Factor investing strategies are increasingly being used in emerging market investing
- Interest in emerging market equities factor investing is rising
- Advocates argue that factor investing is even better suited to emerging than developed market equities
- However, small size and momentum factors are hard to implement
- Low volatility works well in the China A-share market but momentum works badly
If factor investing is a way of imposing order on chaos, by explaining equity performance through certain common characteristics, it is not surprising that interest in applying factors to emerging markets (EMs) is on the rise. EMs are, after all, prone to volatility, including a period of high volatility late last year.
“In the last 12 months we’ve seen quite an uptick in interest in GEM-only factor mandates from institutional investors,” says
Alexander Davey, global head of factor and smart beta product at HSBC Global Asset Management in London, referring to global emerging markets. “That may be because 2018 was quite challenging for traditional emerging market equity strategies. It may be because the relative valuation case for emerging markets is particularly strong versus US equities; it may just be part of a general trend in allocations.”
Based on metrics such as price-earnings, EM equities currently trade at well above their average historical discount relative to US equities.
Davey says he has seen a clear increase in the number of requests for proposal (RFPs) and reverse enquiries – where clients have approached HSBC rather than the other way around – for this strategy, with several expressions of interest ending in allocations.
Responding to the increased appetite, some managers are planning to apply factors to EMs for the first time – OppenheimerFunds plans to launch such a strategy, for example. Lazard Asset Management’s Lazard Emerging Markets Equity Advantage strategy, which uses four factor families, is long-established, by contrast – it was set up in 2011. However, AUM, currently at $2bn (€1.8bn), is on a rising trend. The strategy has achieved an average annualised performance of 4.12%, compared with only 1.26% for the MSCI Emerging Markets index. “We think factor investing has even more merit in emerging markets, because emerging markets are less efficient in pricing stocks,” says Jason Williams, who manages the strategy in London. The greater the efficiency, the more that factor premia will be whittled away as the market seeks to harvest these premia.
The mathematics behind factor investing can be so complex that it can sometimes seem like rocket science. But at least it is the same science for emerging markets.
“Our view is very simple. We apply the same principles to developed and emerging markets,” says Seiha Lok, equity portfolio manager at CPR Asset Management, the quantitative equities arm of Amundi, in Paris. He notes even that the same factors tend to perform badly or well at the same times in developed and emerging markets. For example, in 2017 growth did well in both, and in 2018 low and minimum volatility had a good year “and everything else worked very badly”.
Since the beginning of 2019, low and minimum volatility have fared poorly, but other factors, including low valuation, have shone.
Looking at factor performance over a market cycle, however, differences emerge between emerging and developed market performance.
MSCI has found that momentum does worse in EMs, but dividend yield and earnings yield do better. Raina Oberoi, head of equity solutions research for the Americas at MSCI in New York, says these two factors do well because emerging market stocks comprise “a riskier pool of companies than in developed markets”. Because of this, “there is a natural inclination for a safety cushion, and for a flight to quality when crisis hits”. As a result, “investors are always looking for value-based companies, but at the same time looking for dividends”. In other words, investors want the security of healthy earnings and dividends now, rather than the uncertain prospect of high earnings and dividends at some point in the future.
Price moves driven by momentum, by contrast, are not anchored in hard numbers on balance sheets and P&Ls reflecting what listed companies can offer shareholders in the present.
There is another problem with momentum in EMs. This factor requires a higher turnover in shares, and transaction costs are so much higher in EMs because liquidity is so much thinner.
Mo Haghbin, head of product, beta solutions, at OppenheimerFunds in New York, says momentum can produce a premium in EMs, but “the implementation is a lot trickier because of the transaction costs”. Because of this, he has qualms about strategies founded on analysing price momentum over a short period. Momentum strategies based on the past three or even six months “are very, very dangerous in emerging markets when transaction costs are so high”.
Instead, OppenheimerFunds plans to use 11-month momentum for its emerging market strategy. This design will ignore the most recent month, when the chances of reversals in sentiment are high, but look at the 11 months before that. It already uses this period for its US factor investing.
“We think factor investing has even more merit in emerging markets, because emerging markets are less efficient in pricing stocks” - Jason Williams
As for size, a standard factor in developed markets, he argues that the high transaction costs of EMs, which are particularly high for small-caps make this factor difficult to implement. In any case, Haghbin says, emerging small-caps tend to not to be plugged tightly into the global economy, but are instead “very focused domestically”. In conclusion, for size “harvesting the premia doesn’t necessarily make sense”.
Another key question for any would-be user of factor strategies in EMs is whether the huge mainland Chinese market presents any particular problems or attractions of its own.
MSCI says that momentum works badly for Chinese A-Shares – at least for practical purposes. An MSCI research paper has found that the momentum factor generated an annualised active return of minus 3% between late 2009 and early 2018 (based on simulated performance), relative to the main MSCI China A-share index. This was almost the mirror image of performance for EMs as a whole, which delivered just above plus 3%.
This dire result is explained by Raman Aylur Subramanian, head of equity applied research for the Americas and EMEA at MSCI in Princeton, New Jersey. “It’s not because momentum is not playing out in China,” he says. It is because the market is dominated by fast-shooting retail investors. As a result, “if you want to harvest this particular premium in China, you have to trade much more frequently than in other emerging markets”. MSCI typically re-balances its factor indices twice a year, and this is too slow to keep up with the momentum of the Chinese investor on the street.
However, five other factors offered by MSCI – size, quality, enhanced value, dividend yield and minimum volatility – have all outperformed their equivalents for both general emerging and developed markets. Particularly striking is minimum volatility, which has delivered more than 6% in annualised outperformance.
Given this number, it is not surprising that China Post Global, the international asset management arm of China Post Fund, has opted for a minimum variance (low volatility) fund as its first factor fund for the China A share market.
Danny Dolan, the firm’s London-based managing director, notes that China A-share volatility is not merely twice that of the S&P 500 over the past seven years; it is even about one and a half times more volatile than the MSCI Emerging Markets index. The fund implements its strategy largely by underweighting financials, and overweighting less volatile sectors such as utilities. Dolan explains the general volatility of the Chinese market in part by citing the constraints, on retail investors particularly, on investing overseas. “There’s a tendency to overheat in the domestic market because there aren’t many choices – there aren’t many other places for the money to go.”