Tag Archives: china

Up For Debate Yet Again: Active Vs. Passive But This Time It’s The Emerging Markets

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.

How To Invest In A Slowing China World

By Bryce Coward, CFA Gavekal Capital Blog Yesterday, we gave three reasons why the stabilization seen in China over the last several weeks is just a cyclical pause before the next leg of the slowdown starts anew. Those reasons were that: 1) The current stabilization is almost entirely due to fiscal stimulus totaling about 2.8% of GDP, and that slower growth is in the offing as the fiscal stimulus turns into fiscal drag. 2) The Chinese economy is in a structurally slowing pattern driven by the ongoing and inevitable slowdown, or even outright decline, in infrastructure investment – the driver of Chinese GDP growth for the last decade at least. 3) Market driven prices for things hypersensitive to the level of China’s GDP growth (oil, copper, shipping rates) are all collapsing toward/have broken their cycle lows, indicating more slowing in China, not structural stabilization. The obvious question is then how one positions their portfolio in a world where China is on a structurally slowing growth trajectory. In an effort to not over-complicate things, let’s look at China from the 30,000-foot view. From this perspective we observe two things that will unfold over the next decade. First, investment as a share of GDP will fall from almost 50% of GDP to closer to 35% of GDP, if not lower. Second, consumption as a share of GDP will rise from 38% to around to 50%, if not higher. The first chart below depicts how this transition might play out. Mathematically, this implies growth in infrastructure investment will slow to the low single digits, if not turn outright negative, while growth in consumption continues at a rapid, if not accelerating pace. Now, having just described what in our view is the most likely outcome in terms of the Chinese rebalancing story, the investment implications are not all that difficult to discern. Companies that feed off of Chinese investment in infrastructure will likely struggle and companies that benefit from Chinese consumption will do ok, if not great. What if the Great Chinese Rabalance is not as graceful as we have shown in our chart and the hard-landing scenario comes to pass? In this case the investment implications are likely the same, except that first brand of companies may fall a lot more and the second brand may rise a lot less. (click to enlarge) Ok then, specifically which are the companies, in and outside of China, that one should underweight and which are the companies that one should overweight? Keeping in mind that there are always companies in a given industry that buck the trend due to greater levels of innovation, less debt, different customers, etc., we can break down our bifurcated world along economic sector lines as follows: Now, we’re not saying that every industrial/materials company will underperform consistently for the next decade nor that every consumer discretionary or health care company will outperform, but the cards have been dealt and the odds are breaking in that direction. But here’s the catch: all the common benchmarks for diversified developed or emerging markets (MSCI, FTSE, Vanguard, etc.) are around 50% (or more) allocated to the economic sectors with the largest headwinds in the decade ahead. That means that any diversified EM or DM investment products (mutual funds or ETFs) that look anything like the benchmark are by default leaning into the wind rather than letting it push them. Putting it all together, the following, in our opinion, is the single most important thing investors should be thinking about as they consider core allocations to developed and emerging markets: Do the products I’m invested in or considering look like the benchmark or do they look different from an allocation perspective? It goes without saying that products that are allocated like the benchmark will perform like the benchmark and investors need to decide if that situation is optimal, or not. In our opinion, the answer is clearly, “No”.

How These 4 ETFs Will Benefit From A Rate Hike

With excellent October jobs data, the interest rates hike for December is back on the table. The U.S. economy added 271,000 jobs in October, much above the market expectation of 180,000 and representing the strongest pace of a one-month jobs gain in 2015. The Fed in its latest FOMC meeting also hinted at a December lift-off if the U.S. economy remains on track. In a recent Wall Street Journal poll, about 92% of the economists believe that the first interest rate hike in almost a decade will come at the December 15-16 policy meeting, while 5% expect the Fed to wait until March. The rest expect the Fed to keep cheap money flowing for longer. This is especially true as recent headwinds have faded with substantial positive developments seen in the global economy and financial market lately. In particular, the Chinese economy is showing signs of stabilization on the back of better-than-expected GDP growth data and another rate cut while the Japanese and European central banks are seeking additional stimulus measures to revive their economies (read: China Investing: Should You Buy These New ETFs? ). Further, the U.S. economy is showing an impressive rebound after a lazy summer and is continuing to outpace the other economies. Though the manufacturing sector expanded at its slowest pace in more than two years in October on a weak global economy and strong dollar, rise in new orders spread some hopes in the sector. Consumer confidence picked up in October, as measured by the Thomson Reuters/University of Michigan index, which rose to 90 after dropping to 87.2 in September from 91.9 in August. Unemployment dropped to a new seven-year low to 5% in October from 5.1% in September and average hourly wages accelerated by 9 cents to $25.20 bringing the year-over-year increase to 2.5%, the sharpest growth since July 2009. The solid pay gains will increase consumer spending in the crucial holiday season, which will translate into stepped-up economic activities. Given the recently improving fundamentals, an increase in rates seems justified. As a result, investor should focus on the areas/sectors that will benefit the most in the rising rate environment. Here, we have detailed four of these and their best ETFs below: Financials A rising interest rate scenario would be highly profitable for the financial sector. This is because the steepening yield curve would bolster profits for banks, insurance companies and discount brokerage firms. A broad way to play this trend is with the Financial Select Sector SPDR ETF (NYSEARCA: XLF ) , which has a Zacks ETF Rank of 2 or a ‘Buy’ rating with a Medium risk outlook (read: Rate Hike Coming in December? Financial ETFs & Stocks to Buy ). This is by far the most popular financial ETF in the space with AUM of $18.8 billion and an average daily volume of over 37.2 million shares. The fund follows the Financial Select Sector Index, holding 89 stocks in its basket. It is heavily concentrated on the top three firms – Wells Fargo (NYSE: WFC ), Berkshire Hathaway (NYSE: BRK.B ) and JPMorgan Chase (NYSE: JPM ) – with over 8% share each while other firms hold less than 6.2% share. In terms of industrial exposure, banks take the top spot at 37.2% while insurance, REITs, capital markets and diversified financial services make up for double-digit exposure each. The fund charges 14 bps in annual fees and has lost 1.2% in the year-to-date timeframe. Consumer Discretionary Consumer discretionary stocks also seem a good bet in the rising rate scenario. This is because these typically perform well in an improving economy justified by the healing job market, recovering housing market, surging stock market and expanding economic activities. Further cheap fuel is an added advantage for this sector. One exciting pick in this space can be the Vanguard Consumer Discretionary ETF (NYSEARCA: VCR ) , which has a Zacks ETF Rank of 1 or a ‘Strong Buy’ rating with a Medium risk outlook. This fund follows the MSCI U.S. Investable Market Consumer Discretionary 25/50 Index and holds 384 stocks in its basket. This is the low choice in the space, charging investors just 12 bps in annual fees while volume is also solid at nearly 153,000 shares a day. The product has managed over $2 billion in its asset base so far. It is pretty spread out across sectors and securities with a slight tilt toward Amazon (NASDAQ: AMZN ) at 7%, while other firms hold no more than 5.7% share. Internet retail, restaurants, movies and entertainment, and cable & satellite are the top four sectors accounting for over 10% of total assets. VCR has gained 8% so far this year. Short-Term Treasury Though the fixed income world is the worst hit by the rising rates scenario, a number of ETFs that employ some niche strategies like the iPath U.S. Treasury Steepener ETN (NASDAQ: STPP ) could lead to huge gains. This product directly capitalizes on rising interest rates and performs better when the yield curve is rising. The ETN looks to follow the Barclays U.S. Treasury 2Y/10Y Yield Curve Index, which delivers returns from the steepening of the yield curve through a notional rolling investment in U.S. Treasury note futures contracts. The fund takes a weighted long position in 2-year Treasury futures contracts and a weighted short position in 10-year Treasury futures contracts. STPP charges 0.75% in fees and expenses while volume is light at around 1,000 shares a day. Additionally, it is an unpopular bond ETF with AUM of just $2.5 million. The note has surged 4.6% in the year-to-date timeframe. Negative Duration Bond Negative duration bond ETFs offer exposure to traditional bonds while at the same time short Treasury bonds using derivatives such as interest-rate swaps, interest-rate options and Treasury futures. The short position will diminish the fund’s actual long duration, resulting in a negative duration. As a result, these bonds could act as a powerful hedge and a money enhancer in a rising rate environment. Currently, there are a couple of negative duration bond ETFs, out of which the WisdomTree Barclays U.S. Aggregate Bond Negative Duration ETF (NASDAQ: AGND ) has AUM of $17.9 million and average daily volume of 13,000 shares. This ETF tracks the Barclays Rate Hedged U.S. Aggregate Bond Index, Negative Five Duration. The benchmark provides long positions in the Barclays U.S. Aggregate Bond Index, which consists of Treasuries, government bonds, corporate bonds, mortgage-backed pass-through securities, commercial MBS & ABS, and short positions in U.S. Treasuries corresponding to a duration exceeding the long portfolio, with duration of approximately negative 5 years. Expense ratio came in at 28 bps. The product has gained 0.3% so far this year. Link to the original post on Zacks.com