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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.

Fundamental Items Rarely Affect Valuation

By Rupert Hargreaves Almost all fundamental investors based their research, analysis and investment decisions on the assumption that some positive relationships exist over time between equity valuation and key financial metrics. However, while a large amount of investment activity is based on the assumed relationships between the aforementioned factors, research conducted by S&P Capital IQ, shows that for the past decade it has been impossible to prove a strong statistical relationship between commonly referenced fundamental financial statistics and the direction of the equity market, momentum, and valuation: “Whether we are looking at various measures of profit margin, reported revenue and earnings growth, or even estimated future sales and earnings growth, the past decade’s correlations between price-to-earnings (P/E) valuations and a variety of commonly referenced fundamental financial statistics randomly range between strongly positive and negative readings.” – S&P Capital IQ Global Markets Intelligence Valuation versus fundamental data items Any investor that’s been watching the market for more than a year or two will know that the relationship between the valuation assigned to equities by stock market investors and underlying fundamental characteristics, over time, is extremely complex. There are many internal (stock specific) and external factors that can affect valuations. According to S&P Capital IQ ‘s research on the matter, the only net positive correlation relationship with P/E multiples since 2005 is related to selling, general, and administrative expense margins or the ratio of non-price of goods sold expenses to revenues. The best way to explain this relationship is with a table. (click to enlarge) P/E Valuation vs. Fundamental Data Items Based on a decade’s worth of data, S&P Capital’s research shows that a change in a company’s selling, general, and administrative expense margin is the only factor that will consistently impact earnings multiples across sectors. There is a clear reason for this correlation. Higher expenses will compress profit margins, weigh on profit and ultimately investors will abandon the company, driving the P/E lower. However, it’s unclear why a similar relationship doesn’t exist across other fundamental metrics. Prime example The tech sector is a prime example of an industry where the average P/E does not reflect the underlying and improving fundamentals. After the tech stock market bubble burst in 2000, the S&P 500 technology sector entered the economic recovery cycle in the first quarter of 2002 with a forward 12-month P/E valuation ratio of 54x. Between 2002 and 2010, tech sector valuations continued to be consistently marked down, although, the sector’s earnings growth averaged 23% per quarter throughout the period. The sector’s forward P/E reached a low watermark of 10.7 during Q3 2011 and has only recently started to readjust higher – as shown below. (click to enlarge) Interesting trends Aside from the obvious disconnect between P/E multiples and underlying fundamentals, S&P Capital IQ’s data highlights some other interesting trends. For example, the energy sector is currently trading at a forward P/E multiple of 33, exceeding the levels recorded while exiting the 2001 recession. The energy sector exited the 2001 recession with an elevated forward P/E of 24 that steadily declined to 8.6 by Q4 2005, well into the economic recovery and actually half way through the Fed’s tightening cycle, which took place between June 2004 and June 2006. The sector’s P/E bottomed in 2005, steadily increasing as the price of crude oil continued to rise from $50-$60 per barrel in the final quarter of 2005 to as high as $145 in July 2008. The sector P/E reached a peak of 15.3 in Q4 2008. These historic trends show that the current extreme forward energy sector P/E ratio reflects severely depressed anticipated future earnings per share relative to existing share prices, not unlike the excessive valuations seen at the tail-end of the tech stock market bubble in 2000. The excessive valuation now needs to be worked off as revenue and profit growth slowly becomes aligned with market pricing. The consumer discretionary sector illustrates more contemporary equity market valuation-related issues. Specifically, between mid-year 2004 and mid-year 2006, as the Fed continued to raise short-term interest rates at every Federal Open Market Committee meeting, investors became more cautious toward the consumer discretionary sector, pushing the sector’s P/E multiple down to 18.4 in the second quarter of 2006, from 19.4. Over the same period, sector earnings grew at an average of 8.8%: “Moving ahead to current valuations, the consumer discretionary sector’s forward P/E ratio has averaged 19.1x in the past two years while sector earnings per share growth has averaged 10.5%. Interestingly enough, this figure is close to the average P/E of 19.4x recorded by the sector during the prior period of Fed tightening when earnings grew by 8.8%. From this perspective, investors appear to be comfortable with a prospective Fed tightening cycle, as they were during most of the prior tightening cycle, as long as consumer discretionary sector earnings continue to grow at a healthy pace.” – S&P Capital IQ Global Markets Intelligence

There Is Nothing Total About Total Return

Summary There are several methods for calculating total return, and the results of the different calculations can vary greatly. Total return is an important concept, and for many an indicator of how wisely they invest. Funds, advisors and even individual investors use total return to compare success and profit. Do you as an individual investor know what lies behind the total return concept, and does the number you get actually provide something meaningful to you? We all like to keep a score, and as investors total return is the score to talk about and show off. Unless you are an income-oriented investor, and actually are disciplined enough to only focus on income, your portfolio’s total return will fuel your hubris or smack you down all depending on Mr. Market. So considering the apparent importance of this number we should be talking about the same thing and measure the outcomes that really matter to us. But do we really do that? What is it that you measure when you calculate total return for your portfolio, and can you use the numbers the investment advisors and brokers give you? (click to enlarge) Total return is something I have found a bit difficult to wrap my head around. It is especially hard to calculate total return for a portfolio with cash flowing in and out. I have studied the different total return calculations to try to spot the differences, and decide which one I would use myself. In this article I will sum up my findings, and I hope to initiate a discussion to cast further light on this topic. I’m going to show how total return can be completely different values depending on what you want to measure and how you calculate it. And the “what do you want to measure” part is important – do you want to know how much your portfolio actually grew over a period, or how it performed versus other investment strategies? If you do not have an idea of what and how to measure total return you can end up with numbers that are totally irrelevant , as I have argued before. I will try to show the practical implications of the different calculations using examples. Hopefully that will make it easier to understand why different calculations give different answers. For the examples in this article I will use the daily closing prices from 2015 for Apple Inc. (NASDAQ: AAPL ). There has been quite a bit of volatility in this stock in 2015, so it will serve well as an example of how sequence of returns and cash flow influences total return calculations. Data is downloaded from Yahoo Finance. The simplest form of return: Dollar return Investors are building portfolios to make money grow into more money. Since more money is the ultimate goal, why could we not just measure the return as how much the portfolio value increased? If you started the year with $10,000 and ended with $12,000, with no contributions or withdrawals, the value of your portfolio would have increased with $2,000. You are in fact $2,000 richer at the end of the year. Even accounting for the cash flow is quite simple – just subtract from the year-end value any contributions and add any withdrawals. You will have full control of the increase or decrease in portfolio value. So why are we not happy with just looking at dollar returns? The main issue is that dollar returns cannot be compared across portfolios, and we want to be able to compare our performance against other portfolios. For many individual investors it’s a matter of comparing the performance of a financial advisor or portfolio manager against other providers of these services. To be able to compare we calculate the return as a percentage of portfolio value. In the example mentioned above the percentage return would be 20%. When you have no cash flow this simple calculation will provide your portfolio’s total return. But when we add cash flow to the portfolio the calculation becomes a bit more complex, and you actually have to make a choice regarding the calculation method. How cash flow is handled is actually the only thing separating the different approaches to calculating total return. Single purchase vs. dollar cost averaging Total return for a single purchase of stock is not very complicated. You take the sell price, subtract the buy price, add any dividend received, and divide that total by the buy price. There is no cash flow to complicate the calculations, and you don’t have to worry about reinvesting dividends. If you had bought shares of Apple on January 2nd and held them until October 30th you would have made a nice profit. P 0 = 109.33 (close price on January 2nd 2015) P 1 = 119.50 (close price on October 30th 2015) D = $0.47 + $0.52 + $0.52 = $1.51 Total stock return = ($119.50 – $109.33 + $1.51) / $109.33 = 10.68% This is the return without reinvesting dividends. We can complicate the calculation and reinvest dividends, but still have no other cash flow. Here is the result from a great dividend reinvestment calculator you can find at dividendchannel.com. For this short period (and modest dividend) reinvestment of dividends did not have any effect on the total return. But if you calculate over a longer period it will make a difference if you choose to reinvest dividends or not. We can do another calculation going back to 2012 when Apple started to pay dividends. In this example the total return from Apple increased from 113.27% to 117.52% when dividends were reinvested. We still have only one contribution of cash and a single stock portfolio, but already we have two different numbers for total return. The concept of total return gets more complicated when we start to look at a portfolio that receives monthly contributions, reinvests dividends and where money is withdrawn from the account occasionally. The cash flow will influence the total return calculation, and the sequence of contributions, withdrawals and dividend reinvestment will have significant effect on return calculations along with the stock’s sequence of return. There are two main approaches to this. The first is to ignore the cash flows and sequence of returns – this is called a time-weighted return. The other main approach is to account for both the cash flow, adjusted by the time the cash is at work in the portfolio and the sequence of returns. This is called a value-weighted return. So which one should you use? And which is it that you get from your broker? The short answer is that it depends on what you want to do with your total return. Do you want to compare it to an index or to other investors? Then a time-weighted return is the number you want, and this also is usually the total return you will get from your financial advisor or broker. But not all brokers think this is the best approach. Here’s a screen shot from Motif.com regarding return calculation. (click to enlarge) If you want your total return to more realistically represent the actual performance, in terms of loss or gain of your portfolio, you would have to use a value-weighted return. To show this I will use a portfolio investing $1,000 in Apple stock every month in 2015. As we previously saw, Apple is up over 10% for the year. Below is a table showing the portfolio value for each month of 2015. Date Period Portfolio cash flow Value 01/30/15 $1,000.00 $1,071.62 02/27/15 $1,000.00 $2,184.22 03/31/15 $1,000.00 $3,111.54 04/30/15 $1,000.00 $4,116.69 05/29/15 $1,000.00 $5,314.46 06/30/15 $1,000.00 $6,104.88 07/31/15 $1,000.00 $6,860.34 08/31/15 $1,000.00 $7,368.10 09/30/15 $1,000.00 $8,155.92 10/30/15 $1,000.00 $9,904.50 A total of $10,000 was invested in the portfolio, but the portfolio value was only 9,904.50 at the end of October. The dollar return was -$95.50 for the portfolio despite the 10% appreciation of Apple in 2015. The reason for this is the sequence of returns. The table above shows how the price of Apple soared during the first five months of 2015, and then fell back during the next four months, before the final rally in October. For the portfolio this was most unfortunate. During the “good” months in the beginning of the year the shares from only a few months of contributions benefited from the rise in stock price. For the next few months, new shares were bought at peak prices before the stock tumbled. More shares were bought at a lower cost over the next few months, but even with those fortunate purchases and the October rally the portfolio ended up with a minor loss. Rearranging the sequence of the monthly returns will provide a different return. Many factors clearly have an effect on the return of a portfolio. And the gain or loss of a portfolio is the definitive measure of success or failure as an investor. I have calculated the total return of this portfolio using different approaches to total return to see how well they reflect the experienced success/failure for the investor. Apple stock return 10.68% Portfolio dollar return -$95.50 Simple return on invested capital -0.96% Time-weighted return (monthly periods) 9.07% True time-weighted return 10.64% Value-weighted return (Internal rate of return) 1.85% Value-weighted return (Modified Dietz) 1.87% A bit confusing isn’t it? But it seems quite clear that the value-weighted returns better represent the actual gain/loss of the portfolio than the time-weighted returns. The two different value-weighted returns results from two different methods of calculation. The results in this case were quite similar, but the discrepancies can be significant. Given the finding that the value-weighted return better reflects the actual return of the portfolio, why is the time-weighted return so popular? Imagine you are a financial advisor who told a client to buy Apple in January. The value of Apple appreciated 10% until the end of October, so it was quite good advice. But due to the client’s monthly purchases the portfolio actually ended up losing money. As a financial advisor you might find it a bit unfair if you were compared to other financial advisors based on that loss rather than on the 10% potential gain from the advice. That is the reason for why time-weighted return is the industry standard it allows for comparison based on the advisor’s performance without the client’s influence on the result through cash flow. But as you see from the different time-weighted returns in the table above, there are some traps in the time-weighted return calculation you have to be aware of. The only thing separating the two time-weighted returns above is the choice of sub-periods, but that resulted in a notable difference. Conclusion As an individual investor you might not have a financial advisor. You make your own decisions based on your own research. You are your own financial advisor. You will have to decide yourself what kind of total return you want to calculate for your portfolio. One thing is certain – there is nothing total about total return! Here are some factors that will influence how you calculate total return and the resulting number: Single stock or portfolio? Single purchase or several purchases? Cash flow and purchase dates Time-weighted return or value-weighted return? For time-weighted return: Choice of sub-periods For value-weighted return: Choice of calculation method I will follow up on this article with a few articles that takes a closer look at the different types of total return, how you calculate them and the potential mistakes you can make. Thank you for reading, and please do comment and ask questions! Remember I am just another individual hobby investor. I appreciate all forms of feed-back so I can widen my horizons and learn more about investing!