By Stephen Russell
As the emerging markets asset class has expanded over the past 30 years, so has investor interest in this area, triggering a proliferation of investment options, including index-tracking and style- and factor-focused products.
Lazard’s Emerging Markets Core Equity team has evaluated these approaches and questions their validity. On the one hand, passive products can neglect a significant subset of emerging markets stocks and are restricted by index construction rules. Investing by timing styles or factors, on the other hand, is prone to cycles that can result in undesirable patterns of performance. The team proposes a core portfolio that transcends style considerations, instead relying on fundamental stock selection and risk management relative to the benchmark.
Emerging-market equities have become an important component of global portfolios, due to their long-term performance potential. However, this asset class is prone to oscillations in performance leadership, whether by style (growth versus value) or factor (including high beta versus low beta and high price-to-earnings [P/E] ratio versus low P/E ratio). By its nature, investing with a style or factor focus can result in undesirable patterns of performance, especially during periods of elevated volatility when stocks with a shared orientation tend to move in tandem (more on this later). This can be problematic for investors in search of more predictable excess returns. The concept of core investing has come about as an alternative to style-driven approaches. The average core strategy addresses issues of size (market capitalisation) and style (growth and value). We believe this definition is too narrow and that an emerging markets core equity offering should include a consideration of other characteristics in an effort to improve investment outcomes.
Passive investing has gained popularity across virtually every asset class, including emerging markets equities. Among emerging-market index trackers, the MSCI Emerging Markets Index is the most widely imitated.
While it holds a certain appeal, passive investing in practice does not lend itself very well to the emerging markets due to liquidity issues, as well as the relatively higher cost of trading locally. Moreover, those funds tracking popular emerging-market benchmarks are by extension limited to a narrow subset of emerging-market companies. A decade ago, this may not have been as problematic, as the MSCI Emerging Markets Index included slightly more than one-half of all companies in the opportunity set, defined here as the MSCI Emerging Markets Investable Market Index (IMI). By contrast, at the end of 2013 this figure dwindled to approximately one-third as the number of listed companies increased (824 stocks in the MSCI Emerging Markets Index relative to approximately 2,600 stocks in the MSCI Emerging Markets IMI).
Other drawbacks of benchmark investing include large-cap bias and sector and country concentration. Consider this: The largest 75 constituents of the roughly 800-stock MSCI Emerging Markets Index – or just 9% of all constituents – account for nearly one-half of the index’s total capitalisation. Another quirk of capitalisation-weighted benchmarks means that any gains, however large, in smaller-cap constituents would generally have a negligible impact on an index fund’s performance, which is wasted opportunity.
The MSCI Emerging Markets index is also dominated by financials, information technology, and energy stocks as many of the companies in these sectors are large- cap or mega-cap. Together, these constitute 54% of the index. The largest four country constituents (China, Brazil, South Korea, and Taiwan) represent 56% of the benchmark, with many of the countries with smaller weights having a negligible impact on index performance.
In our view, these flaws can be addressed through active management, which allows for a much more thoughtful approach to investing in the emerging markets, with portfolio positions that are driven by best ideas as opposed to index composition.
Stephen Russell is manager of the Lazard Emerging Markets Core Equity Strategy
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