In this article we cover:
- Despite investors returning to emerging markets as equities recover, most remain under-exposed
- An assessment of active management performance and the markets where it can flourish
- How emerging market inefficiencies lead to passive fund failure and opportunities for stock-pickers
The continued resurgence of emerging market (EM) equities has prompted many investors to revisit their exposure to this engine of global economic growth. Last year EM outperformed developed markets (DM) for the first time since 2012 and the rally has continued into 2017 with EM over 5% ahead in the first quarter, which saw twelve consecutive weeks of equity fund inflows totalling USD 12bn, two and a half times the total amount invested in 2016.
The bulk of this capital has been invested passively via exchange traded funds (ETFs) but it is questionable whether this strategy is effective. Although most active managers generally fail to match their benchmarks after fees, research shows that the most active stock-pickers do outperform. A comprehensive study(1) of 2,740 funds from 1990-2009 found that those with the highest Active Share – a measure of stock selection which identifies the percentage of a portfolio that differs from its index – beat their benchmarks by 1.3% a year on average after fees. Although the period since this study has been challenging for active managers, as central bank intervention has boosted equity correlation and reduced the influence of fundamentals on share prices, signs of monetary policy normalisation in important markets such as the US should see a return to more favourable conditions for stock-pickers, globally.
Exploiting market inefficiency
Index funds need certain features in the markets they are trying to track in order to function effectively, such as minimum levels of liquidity, market capitalisation and trading cost efficiency. When these conditions are not present, the flexibility of active management helps managers to navigate, and often exploit, these inefficiencies. Examples of less efficient markets would be smaller companies and emerging markets, where information can be harder to obtain as companies are often less-well researched. These market imperfections create opportunities for active managers to invest where they see the most attractive risk-reward prospects, irrespective of a company's inclusion or position in an index. By taking a bottom up approach to portfolio construction and employing a broad mandate, managers can build portfolios that are truly different from the market/benchmark, allowing them greater opportunity to outperform.
A recent study(2) of 124 EM funds with combined assets of USD 248bn found that in the decade to last September, highly active funds – defined as those with an Active Share over 75% and fewer than 75 holdings – significantly outperformed less active funds and the passive iShares MSCI EM ETF (see chart). The index fund notably underperformed the benchmark it aims to track by over 10%. The research also found that highly active funds beat less active funds in every calendar year except 2009 and the ETF in every year over the decade.
Passive limitations
It is widely accepted that emerging markets should not be treated homogeneously given the huge economic and geopolitical differences that exist within the region. Although passive investing may provide some limited diversification benefits, with countries at various stages of development it is questionable whether having exposure to all nations at all times is desirable. Blindly tracking an emerging market index also means that investors forgo specialist country, sector and company knowledge that active investing applies to find the best ideas.
The economic advancement of some developing nations has also blurred the lines between EM and DM, for example Korea and Taiwan are categorised differently by different index providers. Investing with EM blinkers misses the opportunities presented by DM-listed companies with sales and assets in the developing world, which are often more attractively valued and better run than their domestic competitors. An example is CNH Industrial, the agricultural equipment and truck producer, currently in the SKAGEN Kon-Tiki portfolio. The company is incorporated in the Netherlands, listed in the US, and has an estimated 50% of its sales and most of its future growth from emerging markets. SKAGEN Kon-Tiki, which currently has an Active Share of 91%, has the flexibility to invest up to 50% of its assets in DM-listed companies with strong EM franchises and currently has 14% invested in this way.
Passive investors similarly forsake true exposure to the developing world as the index doesn't include frontier markets, which have outperformed emerging markets in three of the past five years(3) and often contain attractively valued companies with direct access to high growth domestic and regional markets. Examples include Nigeria's Diamond Bank, Ghana Commercial Bank and East African Breweries of Kenya, all of which contribute to Kon-Tiki's current 4% frontier market exposure. Also, many small and mid-cap EM companies aren't represented in the index, which is weighted towards larger stocks.
This means that passive investors miss the opportunity to invest in faster growing companies with the potential for greater returns (EM small-caps have outperformed large-caps in four of the past five years(4)). SKAGEN Kon-Tiki currently invests around 20% of the portfolio in smaller companies. An example would be Yazicilar, a Turkish, family owned, consumer led, conglomerate which has been one of the strongest contributors to the portfolio so far this year.
The opportunity set for passive EM investors is further reduced by the index's under-representation of preference shares. Preference shares of companies listed in several emerging markets, including China, India and Turkey are omitted completely. In addition to protected dividends, preference shares often trade at an attractive discount to ordinary shares, primarily due to less favourable liquidity terms, giving investors a margin of safety on the valuation as well as the potential for significant gains. SKAGEN Kon-Tiki owns the preference shares of Hyundai Motor and Samsung Electronics, its two largest holdings, which were among the three best performers in the first quarter and have been strong contributors to the fund's returns over time.
Other important considerations for investors are environmental, social and governance factors (ESG). Passive investing is generally an inefficient allocation of resources with capital being deployed towards the largest companies, rather than those generating the best returns; a problem exacerbated in EM where the biggest firms are often poorly run state-owned enterprises, commodity companies or oligopolies. Furthermore, ESG screening and exclusion are not optimal approaches in emerging markets due to limited coverage of companies. Active investment, on the other hand, allows for proper ESG analysis of each company and the opportunity to select value-creating companies with a sustainable competitive advantage while avoiding less appealing, anti-competitive firms, or those involved in controversial industries or practices.
EM economic strength
Despite recent EM inflows, most investors – particularly in the west – still lack sufficient exposure to the world's fastest growing regions; developing economies are expected to grow more than twice as fast as advanced ones for at least the next three years. With political risk rising in many developed countries (while remaining relatively stable across EM) and DM equities trading at a 30-35% premium, investors can arguably reduce portfolio risk through sensible EM exposure as well as boost their returns.
As the headwinds faced by active managers, particularly those with a value focus, appear to be reducing and possibly reversing, conditions appear increasingly supportive for stock-picking. While equity performance is likely to be volatile – the price to pay for higher potential rewards – the imperfections in emerging markets also mean that selective and long-term investment should ensure better risk-adjusted returns.
NB: The term 'index' refers to the MSCI Emerging Market Index unless otherwise stated
Footnotes
1. Active Share and Mutual Fund Performance, Antti Petajisto, 2013
2. Source: Copley Fund Research, 2016
3. Source: MSCI (MSCI Frontier Markets Index vs. MSCI Emerging Markets Index 2012-2016)
4. Source: MSCI (MSCI Emerging Markets Small Cap Index vs. MSCI Emerging Markets Large Cap Index 2012-2016)
5. Source: MSCI Global Investable Market Indexes Methodology, April 2017
6. The preference shares of Hyundai and Samsung are included in the MSCI EM index but at a smaller weighting
7. Source: World Bank Global Economic Prospects, January 2017
8. Source: MSCI, MSCI World Index 2017e P/E 17x and P/B 2.3x vs. MSCI EM Index 2017e P/E 11.9x and P/B 1.5x