Emerging market assets look even cheaper after a period of lacklustre returns.
The fractious relationship between China and the US has been a major headwind for emerging markets over the past 12 months. Emerging markets are generally the beneficiary of free-flowing global trade, and ‘deglobalisation’ has dented sentiment towards the asset class as a whole. However, scratching beneath the surface, there have been pockets of strong performance – and some active managers have made hay.
The headline performance statistics make for uncomfortable reading. The MSCI Emerging Markets index dropped 4.5% in the year to 30 September (in US dollar terms), while the MSCI World was flat over the same period. However, weakness was concentrated in a few areas, notably China and its near neighbours, as the fallout from the trade war hit sentiment. Brazil and Russia, in contrast, performed well, while India sat somewhere in between.
While the escalation of the US/China trade war has put pressure on emerging markets, so have other factors. The broad-based strength of the US dollar relative to emerging market currencies is a key consideration. Emerging equities tend to underperform during periods of US dollar strength – but while many expect a deterioration in the dollar following the US interest rate cuts, it hasn’t happened quickly enough to improve recent emerging market performance.
The deterioration in the global economic outlook has also been unhelpful. Emerging markets always tend to benefit from a rising tide, and economic statistics emerging from the US, China and elsewhere have looked lacklustre. Some market-unfriendly election results – notably from early-stage voting in Argentina – have also knocked sentiment. However, collective funds have fared a little better than the index. The average fund in the IA global emerging markets sector is up 6.9% over 12 months to 2 October, according to Financial Express, suggesting the virtues of active management in an inefficient asset class, and also highlighting the importance within the index of a few key technology names – Alibaba, Tencent – where performance has been unexciting.
Active funds fare best
It is worth noting that no active fund underperformed the index over that one-year period, but there was still a vast disparity in performance between individual funds. At the top was First State Global Emerging Market Focus, up 19.1%. JPM Emerging Markets and AXA Framlington Emerging Markets were also among the stronger performers. At the bottom was MFS Meridian Emerging Markets Equity, down 4.2%. 7IM Emerging Markets Equity Value and Allianz Emerging Markets Equity also lost investors money over the period.
The key difference, says Andrew Hardy, portfolio manager at Momentum Global Investment Management (MGIM), has been style: “The best-performing strategies over the past 12 months have been those managed with a consistent style bias towards high-quality or high-growth businesses, as well as those with overweight allocations to more defensive sectors. In contrast, strategies that are managed with a strong value style discipline have mostly underperformed.” This style bias shifted a little in September, with value performing better, but it is too early to call a change in the market.
The First State fund, for example, held a number of consumer staples companies – Yum China, Tsingtao Brewery – plus a significant weighting in the banks, including HDFC and Kotak Mahindra. Together consumer staples and financials made up around 60% of the portfolio. The JPM fund also had a high weighting (almost 40%) in financials.
Regional allocations have also been a factor. Hardy says: “The Latin America and Emerging Europe regional index returns were both over 10% ahead of Asia over the past 12 months; and within those, Brazil and Russia performed particularly well, with gains of 33% and 29% respectively in sterling terms. Those funds with a bias towards Latin America or Eastern Europe, and away from China and Asia more broadly, have had a favourable tailwind supporting their relative performance.”
A higher active share is also likely to have served funds well. The MSCI Emerging Markets index, to which most funds are benchmarked, has an increasingly significant weighting to China. Chinese equities make up over 30% of the index, with Alibaba and Tencent almost 9% between them.
There may be times when this works well, but over the past 12 months it has left investors very exposed to the US/China trade spat and the problems of Chinese manufacturing. There is also a danger this concentration could get worse as the China A-shares market comes on stream. The China weighting would rise to 40%, should A-shares be fully included at 100% of their free float.
For Scott Spencer, a fund manager on the BMO Asset Management multi-manager team, this is an increasingly important consideration when selecting emerging market funds. “As we tend to have Asian and emerging market allocations, when we’re picking emerging market funds, we want to make sure we’re not just buying more Tencent. We want to find those managers uncovering non-benchmark names. That means looking for emerging market managers that are unconstrained by the benchmark, have higher active share and are willing to go further down the market capitalisation scale.”
He consciously avoids some of the “emerging market funds of yesterday” and looks for managers taking positions in countries such as Nigeria or Vietnam. He adds: “There is always something going on in emerging markets and certainly the recent problems in Argentina aren’t helpful, but they do offer some of the best opportunities for long-term economic improvement.”
Long-term top performers still showing strength
|Templeton Em Mkts Smaller Cos||1.84||9||46.67||5||129.47||1|
|JPM Em Mkts Small Cap||9.05||3||59.07||2||129.32||1|
|Hermes Global Em Mkts||9.95||2||80.30||1||128.05||1|
|Aberdeen Standard Sicav Em Mkts Sm Cos||10.21||2||22.41||10||120.75||1|
|Baillie Gifford Em Mkts Growth||9.29||3||70.64||1||119.57||1|
|Baillie Gifford Em Mkts Leading Cos||11.62||1||73.05||1||113.67||2|
|JPM Em Mkts||17.82||1||72.29||1||109.74||2|
|GS Em Mkts CORE Equity Portfolio||-0.05||10||55.04||3||105.61||2|
|T. Rowe Price Em Mkts Equity||9.58||3||68.02||1||103.56||2|
|ASI Em Mkts Equity||10.33||2||39.74||8||102.77||2|
Note: Table shows performance and decile ranking for the top 10 funds over 10 years in the IA global emerging markets sector. Source: FE Analytics, to 3 October 2019
Uncertain times ahead
From here, the sector faces some uncertain times ahead. Although there is still growth in many emerging markets, there is the potential for disruption. The recent economic crisis in Argentina may cause contagion, for example. Equally, there remains a question over whether the China/US trade war will see any sort of resolution and if so, whether there will be a relief rally in emerging market assets.
David Jane, fund manager of Miton multi-asset funds, is quite optimistic: “China’s economy continues to grow at above 6%; this is slower than historic numbers, but it remains a solid figure. This is despite some impact from the trade war, as domestic and regional growth takes over from exports.
“While some commentators seem to be perennial China bears and others bulls, we try to take a balanced view. The years of massive growth in China have passed, but it remains a region with above-average growth as its economy matures. We expect the trade war to continue, but its impact to reduce and remain manageable. The economy should continue to refocus on domestic consumption and regional trade.”
If emerging market assets looked cheap before, relative to developed markets, they look even more so today following a period of subpar performance. As the index becomes increasingly focused on China, however, it may become important for investors to find a manager willing to take positions away from the benchmark, particularly if the trade war rumbles on.
Spotlight on TT Emerging Markets Equity
TT International is the BMO multi-manager team’s choice for emerging market exposure. They favour TT’s Unconstrained fund, but retail investors can invest in the group’s ‘core’ emerging market fund. The BMO team like TT’s approach, which is genuinely active, goes further down the capitalisation scale and avoids some bigger markets.
The fund blends top-down analysis of countries and currencies with detailed company analysis. Top-down analysis is expected to contribute about a third of long-term performance. Detailed fundamental stock analysis should drive the remainder.
The portfolio is concentrated in 50-60 stocks. It has an active share – the extent to which the fund varies from the benchmark – typically above 80%. The fund will hedge currency, allowing the managers to take exposure to good companies in weaker markets. Over the past five years, the team has outperformed in both rising and falling markets.
The group believes larger markets in the index – China, Taiwan, Korea, Brazil, Russia, and South Africa – offer the least attractive investment options and have little scope for secular growth. Their demographic profiles, for example, look more like those of developed markets. Therefore, the managers spread their net far wider for opportunities, and the fund won’t look like many of its peers or the MSCI EM index.
TT beats gem sector in bull markets