Eaton Vance Tax-Managed Emerging Markets Fund dares to tread where other funds don't.
With many emerging markets suddenly down from their all-time
highs, investors need to look beyond familiar territory toward less
traveled corners of the globe for promising growth opportunities,
according to Cliff Quisenberry, manager of the Eaton Vance Tax-Managed
Emerging Markets Fund. "It pays to be a contrarian after emerging
markets have made a big move," he says. "If certain markets have had a
strong run, redeploying assets to places where stocks have
underperformed makes a lot of sense."
Like other emerging market fund managers, Quisenberry maintains a
presence in the usual roster of more "established" up-and-coming
countries such as Brazil, Korea, Taiwan and South Africa. But unlike
most of his competitors, he also ventures into more exotic locales
where the water and political climate is a bit iffier, such as Vietnam,
Romania, Venezuela and Croatia. He emphasizes that investments in
smaller foreign markets, which represent about 15% of assets, are a
prudent move toward diversification rather than a daring romp into
exotic territory in search of outsized returns.
"Korea, Taiwan, South Africa and Brazil make up over 50% of market-cap-weighted, emerging market indexes, so the influence of these countries on investment returns is enormous and there is high per-country risk," he says. "We want to spread out country weights more evenly. The portfolio structure underweights larger markets relative to the index, and overweights smaller ones where valuations are cheaper."
Valuations in smaller markets are often more favorable because most investors have yet to discover them. By contrast, the long, successful run of emerging market funds has attracted hoards of investors to markets once considered off the beaten path. According to Merrill Lynch, investors poured $34 billion into emerging market funds during the first quarter of 2006, eclipsing the $25 billion of inflows into the funds for all of 2005. The inflows followed three years of a rally in emerging market stocks that began in 2003. During the first four months of 2006 the average diversified emerging markets fund had a total return of 20%, according to Morningstar, after an increase of 31.6% in 2005.
The bounce-back followed a long period of underperformance following
mid-'90s disasters such as the 1994 Mexican peso crisis, the collapse
of Thailand's market in 1997 and Russia's default on its government
debt in 1998. But by the end of the decade fiscal and monetary reforms
were helping improve emerging market economies, while a drop in
interest rates lowered the cost of borrowing. Interest from investors
perked up even more as U.S. investors began looking overseas for better
Quisenberry remains confident about the long-term prospects for emerging market countries, and says their economic growth will likely outpace that of more developed, mature economies. And despite a multiyear run-up, he says, the markets are fairly valued by some measures. Recently, the Standard & Poor's IFC Investable Emerging Market Index had a price earnings ratio of 15.1. Over the ten years ending in December 2005, it averaged 16.7.
But he's concerned about the short-term impact on valuations if cash continues to flood these markets, and the possibility of a retrenchment after such a massive upward move. A rise in interest rates in heavily leveraged emerging market countries could also slow economic growth. "Long term, I'm not worried, but over the short term you never know," he says. "But I would have said the same thing two years ago, and look what has happened since then."
A Systematic Approach
Regardless of whether the long run in emerging market stocks continues, Quisenberry will continue using a top-down strategy that focuses first on countries and sectors, and then fills in the bigger picture with a representative sampling of stocks. About 90% of the fund's value added relative to its cap-weighted index comes from country selection and weighting rather than stock picking prowess, he says.
Unlike most emerging market managers, who use a market-capitalization-weight strategy based on an index, Quisenberry uses a systematic investment process that divides the 39 countries and 914 stocks represented in the Fund's portfolio into four tiers containing equal country weights. More-developed markets such as Korea, Taiwan, Mexico, Russia, South Africa and China are in the first tier, each carrying 6.8% of the overall allocation. Tier-two countries are viewed as "mid-cap" emerging markets and are each allocated 3.4% of the portfolio. This tier includes countries such as Malaysia, Poland, Israel and Hungary. "Frontier countries," are divided into two tiers. The smallest, such as Nigeria and Vietnam, receive 0.84% weightings, and the larger ones, such as the Baltics and Morocco, receive 1.68% weightings.
The differences in the fund's makeup versus emerging markets indexes can be dramatic. While Korea represents about 20% of the S&P/IFC Investable Emerging Market Index, it accounts for only about 6.8% of fund assets. Taiwan represents about 15% of the index, but only has a 6.8% target weighting in the fund.
Smaller countries have outperformed larger ones over the last decade,
he says. Over the ten years ending December 31, 2005, the smallest
emerging market countries delivered an annual return of 19%, compared
with a -5.2% drop for the largest countries. Because they remain
largely undiscovered by investors around the world, he adds, smaller
emerging markets have a lower correlation to each other than do larger
ones, and to markets in the United States.
He cites Vietnam, where the fund has had a presence since 2001, as an example of "a great country that investors have ignored." Originally, he invested there to broaden the fund's exposure to the Asian markets. Since then, it has evolved into a country that should see economic growth in the 7% to 8% range this year, and will soon join the World Trade Organization.
Quisenberry acknowledges the risks of investing in frontier countries, including unpredictable political and economic activities, inconsistent levels of data and information disclosure, and the typically high cost of transactions and trading costs in these markets. But he counterbalances them by setting limits on individual stock purchases so that they do not exceed a days' worth of trading activity, and spreading his bets over a wide range of countries and securities. And eventually, he says, small markets grow into more established ones-a philosophy he had in mind when he first invested in China back in 1997, when that market's correlation to the rest of the world was very low and investor interest was minimal.
If a country exceeds its target weight by 50%, the fund will rebalance
and reallocate the extra capital to other countries in the portfolio. A
country with a target weight of 3.4%, for example would be pared back
to that level if its allocation rose to 5.1% of assets. He removes
countries if they become part of a developed market index, if a major
constituent becomes nationalized or if the long-term viability of the
market becomes questionable.
Stocks are divided among the utility, consumer, financial, industrial and resource sectors. Within each country, Quisenberry overweights less dominant sectors of the economy and underweights those with a stronger presence. In Brazil, for example, the fund is currently underweight in basic materials and overweight in the consumer sector. "The idea is that emerging market economies will broaden and diversify, so we want to be in areas that will grow," he says. At 21.6% of assets, financials represent the largest sector of the portfolio.
Because of its unique structure, fund performance often diverges from that of the benchmark. During the first quarter of this year, for example, the portfolio outperformed mainly because of underweight positions in Korea and Taiwan, which had low-single-digit returns and were among the worst-performing countries for the quarter. The damage from underweight positions in Brazil and South Africa, which saw strong returns, was offset by higher exposure to smaller emerging markets like Indonesia, Morocco, Vietnam and Croatia. Holdings in those markets saw returns in excess of 25% for the quarter. Longer term, the fund has outperformed the average fund in Morningstar's diversified emerging markets category since its inception in 1998, and has outperformed the MSCI Europe, Australasia and Far East (EAFE) Index in every year except 2000.
As its name suggests, Eaton Vance Tax Managed Emerging Markets Fund
keeps an eye on tax efficiency. The fund's turnover ratio was just 7%
for the most recent fiscal year, much lower than that of the average
emerging markets fund. "We're not stock traders or country timers," he
says. "Except for some tax-loss harvesting, we like to buy and hold on."
The volatility in emerging markets provides ample opportunity for loss harvesting in the portfolio. While the fund generates some income, it has had no short- or long-term capital gains distributions since 1998. Its 18.07% after-tax annualized return from its June 1998 inception until March 31, 2006, is just a shade lower than its pretax return of 18.81%.
Despite a strong run over the last several years, ample loss
carry-forwards are available to offset gains in the future, he says. A
low expense ratio of 0.95 %, and a $50,000 investment minimum that bars
most retail investors, complements the tax-sensitive strategy.