Passive vs. active investing is another
issue in the red-hot emerging markets sector.
It's 2006. Do you know where your correlations with
international stocks are? Right about where they were ten years ago,
actually, despite all the globalization hype. That means from a
diversification standpoint, the story in foreign equity investing
remains emerging markets, a term coined in the early '80s to denote
middle- and low-income countries and nowadays often represented by the
MSCI EM Index. A subsector dubbed the "frontier" economies (nations
with the tiniest market caps, such as Croatia, Estonia and Botswana,
measured by the S&P/IFCG Frontier Composite Index) has scant
correlation to U.S. equities (see Figure 1).
Yet concerns about the asset class's recent fortunes
have some investors muttering "bubble." Last year, the Mexican stock
market jumped nearly 50%; Egypt's, about 150%. Among the countries
whose indexes reached new highs was Dubai, which crested in August-then
promptly shed half its value over the next seven months. With such
gut-wrenching performances, advisors have to educate clients at both
ends of the risk-tolerance spectrum about the asset class.
"Sometimes an aggressive client will almost like it
too much and want to bet the farm on, say, China," observes David
Cowles, director of investments at Mosaic Financial Partners in San
Francisco. Conversely, conservative investors need reassurance. "For
clients who are concerned that emerging markets are too risky, we have
to demonstrate the diversification benefits of including these stocks
in their portfolio," says Cowles. His standard equity allocation to
emerging markets is 9%.
But you'd better explain the risks, too, he adds,
because there are some unique ones. Emerging markets are not like
developed nations. Historically, budding economies have been more
sensitive to interest rate movements and more prone to bouts of
inflation frequently triggered by sudden shifts in capital flows.
Today, the political systems remain corrupt and unstable, the rule of
law weak.
The capital markets in many developing countries are
thin and immature, too, so trading is expensive, although costs are
coming down as exchange volume increases. Still, U.S. fund managers pay
about 40 basis points to trade in Thailand, one way, and likewise in
Turkey. Even in Hong Kong the commission is around 20. Illiquidity
costs extra. It creates wide bid-asked spreads, in many cases. Plus, a
fund's trade can move the market price as the broker fills the order.
That said, emerging markets as a group appears less
risky than when the asset class soured a decade ago. In fact, "the
fundamentals have never been stronger," says Nathan Sandler, manager of
TCW Emerging Markets Income Fund. "Economic stabilization and
structural reforms have been the catalysts for a transformation process
leading, ultimately, to higher relative growth rates, declining
inflation, an expanding role for the private sector and gradually
improving living standards," Sandler says.
The recent run-up in commodity prices is a big part
of the story, adds Jeff Grills, co-head of the emerging markets debt
team at JPMorgan Asset Management. For example, the bonanza allowed raw
materials exporters Brazil and Argentina to prepay their International
Monetary Fund loans a few months ago.
Wealth spawned by an improving economy further girds
its soundness, as burgeoning domestic markets create national
self-sufficiency. "In the past, most emerging economies were based on
exporting to the U.S., so if the U.S. got a cold, they got pneumonia,"
says Joseph Devine, senior-vice president and portfolio manager at
Nicholas-Applegate Capital Management in San Diego. "Now that emerging
economies are more focussed on domestic consumers, they could continue
performing well if the U.S. economy slows down."
As emerging economies strengthen, many get re-rated.
In 1997, about 10% of the JPMorgan Emerging Markets Bond Index Global,
which tracks government debt issues, was investment grade. "It is now
over 40%," says Gunter Heiland, Grills's co-head at JPMorgan Asset
Management.
Risk: The Big One
Still, one danger has not abated: country-specific
risk. Volatility can be sky-high, only to be exacerbated by a crisis at
any moment. Fortunately the risk is easy to mitigate because the
various emerging markets are remarkably out of sync with one another,
and have been for years. A 2002 Federal Reserve Bank of New York study
found an average correlation of .19 between eight of the larger ones
from 1976 to 1999.
That's not much different from the last five years'
.20 average intercorrelation between a slightly different set of
countries calculated by Cliff Quisenberry. The portfolio manager at
Parametric Portfolio Associates in Seattle and subadvisor of the Eaton
Vance Tax-Managed Emerging Markets Fund says that the smallest emerging
economies are even more uncorrelated-.10 for the last five years, on
average. That helps explain why the S&P/IFCG Frontier Composite
shows greater returns for that period, with lower risk, than the
large-country-weighted MSCI EM (Figure 2).
Invest Actively Or Passively?
There are good arguments for both investing styles,
and against them. The knock against active (besides underperforming the
MSCI index, on average) is high cost. In addition to the trading
expenses funds can rack up internally, Morningstar says you'll pay the
average active manager a tidy 195 bps.
Unfortunately, passive strategies may not offer the
requisite diversity. Just four countries-South Korea, South Africa,
Brazil and Taiwan-account for 51% of the Barclay's iShare
exchange-traded fund that tracks MSCI EM, and 59% of Vanguard's
Emerging Markets VIPER ETF, which emulates a different barometer. The
iShare also suffers from company concentration-Samsung Electronics is
more than 6% of the portfolio, and four other holdings weigh more than
2.5% each.
In theory at least, active management should pay off
in this asset class. Emerging markets are less efficient than developed
ones, no question. Therefore astute investors have greater opportunity
to snare excess returns, or alpha, if we are to believe the
efficient-markets hypothesis.
Devine, a top-quartile manager whose Emerging
Markets Opportunities Fund has handily outperformed the index, takes a
bottom-up growth approach. He frequently favors companies doing
business with locals. "The domestic consumption theme is the real story
in emerging markets right now and will continue to be," he asserts. One
of his current favorites is Brazil's Cyrela Realty, a high-end
residential property developer. Falling interest rates in Brazil,
rising consumption and pent-up demand for real estate could take this
successful company even further, he says.
Another pick is Hengan International-"kind of the
Kleenex of China," Devine calls it. In addition to tapping China's
domestic consumption tidal wave, Hengan has established itself as a
quality brand, a leverageable marketing strategy. "When there is wealth
affect, people begin to look more at quality than pricing," he says.
Quisenberry is also optimistic. His strategy, which
has beaten the MSCI EM over the last half-decade with less risk,
involves overweighting stocks in small countries, relative to the
index, and rebalancing aggressively. "The combination of these
countries' low intercorrelations and high volatility means that if one
is down a lot, you can usually find another that is up a lot.
Rebalancing capitalizes on that," he says, adding that his fund
currently holds companies in about 40 countries.
Another benefit of rebalancing is the self-imposed
contrarianism. It helps lower illiquidity costs. "We're selling when
we're overweight because the market has done well and everybody else
wants to buy, and we're buying when everybody is selling," Quisenberry
says.
Active funds, however, have a great unknown:
currency exposure. Fund companies typically don't indicate whether they
hedge it, says Andrew Clark, an analyst at Lipper, a Reuters company
that analyzes mutual funds. "You can't usually determine how much of a
fund's return is due to currency movements and how much is the result
of stock picking," he says. "Most fund companies don't disclose that
anywhere, to anybody."
But Is There A Bubble?
No, says Devine. "Valuations on the whole are still
pretty compelling. The MSCI EM's forward P/E ratio is lower than that
of the European, U.S. and Japanese markets, although certain countries
are overvalued, like India. We are seeing excessively high valuations
there."
Perhaps the strongest hint of bubble is that
investors seem eager to assume greater risks in emerging markets while
accepting smaller potential returns. Devine cites growing interest in
small- and mid-cap companies as well as in the frontier markets.
Moreover, some managers are staking private equity positions, he
claims. "The risk appetite in emerging markets has grown stronger,"
Devine says. "But even if there is a bubble, it could be five years out
with plenty of opportunities in the meantime."