Summary Emerging Market Indexes are not representative of the overall universe. The commodity boom caused a widespread increase in asset prices, hurting active management. Falling commodity prices should create differentials in Emerging Market countries and companies, benefiting active management. When the term “emerging markets” was coined in the early 1980s it was an exciting time for those investors attracted to this young, inefficient, and rapidly growing set of markets. Earlier on in its evolution, if an investor could stomach the added risk, actively managed emerging market investments offered a very attractive and outsized return profile. Over time though, as these markets matured in size, sophistication, and popularity the differentiation between the active and passive investment approach began to narrow and as this occurred investors began to question whether it was still possible to earn alpha, or outperformance, through active management. At Lynx, we continue to believe emerging market active management is a value added proposition. In terms of number of securities, the emerging market, or EM, universe is very large, yet the interaction most passive investors have with these markets is through the MSCI Emerging Markets Index, which is a poor representation of the overall market. The index includes roughly 800 individual securities, while the overall emerging market universe has over 10,000 public companies. Additionally, there is the issue of sell-side analyst coverage or lack thereof (chart 1); while the number of companies in the BRIC countries far exceeds those of the S&P 500, the average number of analysts covering these names is less than half. More so, of the 800 securities included in the index over 650 are State Owned Enterprises or “SOEs”. SOEs are companies either owned by, or greatly influenced by, their respective governments; well-known examples are Gazprom (GSPFY) ( OTCPK:OGZPY )(Russia), Petrobras (NYSE: PBR ) (Brazil), and China Mobile (NYSE: CHL ) (China). The inherent risks associated with such companies are typically very different from private enterprises, as their balance sheets and overall strategies are most likely driven by a country’s geopolitical goals rather than by financial motivation. When investors purchase an MSCI Emerging Market Index based ETF, roughly 30% of the holdings are SOEs, ultimately adding additional risks that may not be fully appreciated. Chart 1 Now let’s turn to active management and the opportunities it may provide. Within the developed markets, the increasing level of efficiency has made it very challenging for active managers to outperform. Originally, the lack of efficiency among the emerging markets as compared to the developed countries was a significant talking point for EM active managers, but the question today is, does this dichotomy still exist? Through the use of statistical tools such as cross-volatility, correlations, and sector, country and stock dispersions, many have attempted to answer this question. Through a joint review by Lazard, Duke University and Russell Indices, it was discovered that dispersion between EM securities has actually increased in recent years, while in past years it had been fairly static (chart 2). However, recent research also indicates that correlations between various countries in the emerging markets have been moving upwards as of the mid-2000s (chart 3). In 2006 through 2009, correlations between the countries increased, while sectors, already high, remained elevated. The overall increasing correlations in the asset class, in theory, should reduce the opportunity for active management, but let’s combine the above statistical findings with today’s environment. Until recently, China has been the major driver of growth for both emerging countries, as well as commodities. Today these dynamics are shifting as China’s growth is slowing and transitioning to a service based economy. Commodity prices have plummeted in the last year, a sign that the rising tide that lifted all ships in EM over the last 15 years has passed. As a result, the rising correlations between countries, likely a function of the general commodity price boom, should begin to subside. This should cause the country correlations to begin to fall again, opening the door for more active management opportunities. An example that exists now is that of China and India. As Chinese growth has fallen, causing commodities to plummet, India has seen its economy expand, as it is a net importer of energy and is far more diversified than China. This kind of dichotomy should replay itself across many of the index constituents in the coming years. To see a similar example of the relationship between a macro boom, indiscriminate asset price appreciation and the struggles of active management in such an environment, please refer to the Lynx white paper titled, “How Much is Too Much to Pay for Performance: Our Views on Active and Passive Investing,” which lays out our argument for how the U.S. QE caused reduced cross-volatility between domestic stocks. In such an environment the value that active management brings to an investment universe is bound to be masked. Chart 2 (click to enlarge) Chart 3 *Lazard, “Country and Sector Contagion in Emerging Markets” To recap, this paper has discussed the case for active management in EM, and has provided data which suggests a reduced opportunity set for the strategy. Now let’s review actual emerging market mutual fund performance. RBC conducted a study indicating that EM mutual funds have maintained 2% of outperformance over the MSCI Emerging Market Index over a 5 year rolling time period (chart 4). What is telling though is that in recent years the outperformance has narrowed from over 7% in 2000 to 3% in 2014. The tightening may reflect the increased correlations between countries discussed above. However, the argument for active management still holds as outperformance has been maintained. In addition to overall outperformance, outperformance by individual managers also proves to be persistent (chart 5). Top tercile EM Fund managers have maintained top 2 quartile performance in almost 70% of quarters over a 3 year period, indicating that it is possible to outperform the market over time. Chart 4 (click to enlarge) Chart 5 (click to enlarge) In conclusion, though we have shown issues associated with both the active and passive approach, all told we do not believe investing passively in emerging markets is the ideal option. Active management, which comes in various forms, not only better maneuvers through these markets’ associated risks, but it takes advantage of shifting market dynamics and individual opportunities that a quantitative, market cap weighted index approach is likely to overlook. It is also important to emphasize that the most successful emerging market allocations will be those made by investors who are comfortable and accepting of a long-term investment period.
By Jim Freeman, CFP ® The below chart shows how much emerging market equities have underperformed the S&P 500 (NYSEARCA: SPY ) since the financial crisis. It also shows how these stretches of underperformance and outperformance are not unusual. The key to success in investing in emerging markets is to rebalance and add to positions during periods of underperformance, and to rebalance and take profits during periods of outperformance. Having a dedicated allocation to emerging market equities and rebalancing back to this allocation systematically helps you accomplish this. See the graph below to see what would have happened to returns if an investor had held a 50/50 portfolio of emerging markets and the S&P 500 and rebalanced it back to 50/50 at the end of each year during this period. As you can see, the returns would have been 11.6%, or 1.5% better than those from the S&P 500. (click to enlarge) We normally allocate roughly 3-6% of a clients’ portfolio to emerging market equities. We use either the Vanguard Emerging Market fund or the DFA Emerging Market Core fund – both are highly diversified. The Vanguard fund holds 980 stocks, and the DFA fund holds 3,807 stocks. Many people believe emerging market equities will provide higher returns than the S&P 500 over the next market cycle, due to their recent underperformance. We would not be surprised to see this happen, since it is a well-established pattern, as the first graph illustrates. We plan to keep our clients’ allocation to emerging markets consistent, and we will also do tax swaps to lock in losses that can be used to offset gains in other areas of their portfolios. *The above graphs were taken from Ben Carlson’s blog, “A Wealth of Common Sense – Personal Finance, Investments & Markets”. Share this article with a colleague
By Morgan Harting A midyear sell-off in emerging-market stocks highlighted the challenges investors face in volatile times. We think a flexible approach that spans the asset classes can help. Equities dropped by about 25% between April and August, and volatility spiked to levels not seen since the mid-2013 “taper tantrum.” The cause: investors fretted about slowing Chinese growth, weaker commodity prices and looming US Federal Reserve rate hikes. It was particularly tough for passive equity investors whose exposure was concentrated in the BRIC countries – Brazil, Russia, India and China. Don’t Pay for Beta in Emerging Markets This experience seemed to reinforce the notion that investors shouldn’t “pay for beta,” particularly in emerging markets. Passive equity strategies in that arena can be as much as 50% more volatile than in developed markets. The added return needed to justify a passive equity allocation requires a lot of conviction – or disregard for higher volatility. The good news is that emerging markets are still pretty inefficient. Active managers can add value by generating higher returns to justify higher risk, or by reducing the risk in passive strategies. We think the flexibility to tap multiple asset classes in one portfolio – including bonds – can be effective. It’s a compelling way to get more active, seeking to dampen volatility and improve risk-adjusted returns. Episodes like the taper tantrum – a global sell-off across asset classes – can disrupt things. But we think those are the exception, not the rule, in cross-asset diversification. In the recent downturn, multi-asset strategies did indeed outperform passive broad-market equity strategies. Multi-Asset: Newer to Emerging Markets Developed-market multi-asset strategies have been around for a while, but the emerging-market versions are relative newcomers. Many investors still prefer asset-class “pure” emerging-market strategies: all equity or all debt. As the thinking goes, it’s better for managers to focus on asset-class expertise than venture into other areas. We think high volatility in passive emerging-market equity changes the argument. Investors should use every tool to reduce risk and preserve returns. Multi-asset emerging-market approaches offer a tool that controls volatility better than just moving to lower-volatility stocks. The average volatility of emerging-market stocks? It’s 22% over the past decade. For bonds, it’s less than 5%, and with much less downside risk. The recent sell-off in emerging markets has made the volatility and downside risk-reduction benefits more evident, as these managers have outperformed meaningfully. The Case for Crossing Asset-Class Boundaries Granted, some active managers are very skilled in individual asset classes. But no matter which emerging-market asset class you’re in, the main return driver is broad emerging-market risk. The proof is in the return patterns. Over the past decade, the correlation between emerging-market stocks and bonds has been 0.7, much higher than the 0.1 between developed-market equity and debt. 1 With so many common return drivers among emerging asset classes, it seems to make more sense to manage emerging-market equity and debt together in a single portfolio than it does with developed markets. After all, the correlation between US and Japanese stocks is just 0.5, 2 but it’s hardly controversial anymore to suggest one manager for a global equity portfolio. Many investors want to take part in emerging-market growth and may see today’s attractive valuations as an enticing entry point. But they also might question whether it’s really worth it after factoring risk into the equation. We think multi-asset approaches offer a way to reduce some of that risk. Morgan C. Harting, CFA, CAIA Portfolio Manager – Multi-Asset Solutions 1,2 For the 10-year period ending September 25, 2015. Emerging-market stocks represented by the MSCI Emerging Markets Index; emerging-market bonds by the J.P. Morgan EMBI Global; US and Japanese stocks by their respective MSCI indices. Disclaimer: MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.