By Nick Samuels
The emerging markets (EMs) represent 87% of the world’s population and 60% of global GDP. Yet despite EMs growing economic prominence, institutions and pension funds have yet to fully embrace the asset class. Many institutional investors don’t hold dedicated allocations to EM equities, but they will have exposure through their diversified growth or global equity strategies that have EM holdings. The question is whether this represents the best way to access an asset class that represents such diverse and compelling investment opportunities.
One of the reasons that EMs do not have not a greater slice of institutional allocations is embedded in psychology. Local managers in EMs often refer to “tourists” who stop by every so often and buy the obvious, liquid names, missing out on interesting opportunities only to disappear again at the first sign of trouble. They tend to get scarred by this experience and take a long time to come back again.
The sheer complexity of emerging markets is another reason for institutional restraint in the asset class. The banner of EMs covers places as diverse as Chile, Poland and Thailand. Furthermore, the dynamics can alter dramatically in the EM world. For example, countries like Russia or Peru will, at times, suffer from lower commodity prices whereas Korea and India will be the beneficiaries. There are also unique challenges in understanding the politics, governance, corruption and how local investor bases behave, let alone the logistical challenges of covering the corners of the globe.
However, a lack of understanding or fear of EMs should not be the reason to avoid rationally assessing EM opportunities. The onus is on institutional investors and consultants to gain a better understanding of emerging market dynamics and unlock the best ways of finding exposure given the associated risk appetite. The reality is that institutional investors looking for dedicated exposure have myriad options, from dedicated global EM strategies to regional and single country funds. There are also funds that include frontier markets, low-volatility funds, long-short funds and dedicated EM small cap funds. Most of those options can then be accessed via fundamental active managers, systematic managers, smart beta and passively.
In my view, EM benchmarks are not particularly attractive. They typically have a high concentration of government-owned companies that tend to put shareholder interests behind creating jobs or boosting economic growth. In addition, many of the largest benchmark countries, such as Brazil, Russia and South Africa are big commodity exporters that could be on the wrong side of a prolonged commodity slump.
Active management is potentially more attractive, but with such a large expanse of the globe to cover it suggests that big teams of analysts are needed, who are then likely to suffer from communication breakdowns, staff turnover etc… Smaller teams have to really focus on sub-sets of style or geography.
Local investors tend to run regional or single country funds and have deep knowledge of the companies and the nuances of the markets they invest in. They typically get better information than managers based in New York or London, yet they tend to lack the rigorous investment process of the Western managers which leads to behavioural errors and levels of risk management that institutional investors may not be comfortable with.
Systematic strategies are one potential solution, especially for investors looking for a single allocation. Data in EMs has improved immeasurably over the last decade and quantitative managers and even smart beta solutions can offer the breadth of coverage that is tricky for a fundamental manager.
Historically factor-based strategies have worked well in emerging markets. Perhaps surprisingly, taking a value approach has worked especially well. Investors accessing EMs looking for growth have tended to overpay for it and a focus on cheap companies has been a repeatable way to generate excess returns. Other factors that exploit behavioural bias in market participants, such as momentum, quality and low volatility have also worked well in EMs, as human behaviour is largely the same around the world, whether it is happening on the exchanges of Wall Street, Bangkok or Sao Paulo.
These styles can be accessed systematically these days, but experienced fundamental managers running high active share, concentrated portfolios that follow such styles are also worth considering, particularly if they are not encumbered by large assets under management. Liquidity is still a significant issue in EMs, and managers running a lot of money find it hard to generate excess returns, especially when they are facing a wall of redemptions.
Over the last few years of what has been a persistent bear market, value has struggled and quality orientated and low-volatility strategies have been the most successful in relative terms. This has left certain parts of the market, such as consumer staples companies, historically very expensive, even to developed market counterparts.
If EMs return to favour, it is therefore highly unlikely that market leadership will be from the expensive defensive names that recent successful manager track records have been built upon. Institutional investors will need to flip their past performance screening on its head to find the likely winning strategies of the future.
Nick Samuels is head of equity manager research at Redington
