Why Active Management Makes Sense When Investing Internationally
Over the last two decades "passive" investing through index-based mutual funds
and exchange-traded funds has become a staple of the investment industry. But
when you think about it, indexing really isn't that passive. And when it comes to
performance, it falls short more often than many people think.
Market cap weighted indexing, the oldest and most common variety, is essentially a
momentum-driven strategy. When stocks and sectors become increasingly popular
they occupy more and more space in the index's weighting and account for a larger
share of its performance. Expensive stocks rise to the top of the index scorecard
while more reasonably priced ones, even those of good companies with strong
balance sheets, occupy less space.
Indexing tends to work best in a strong bull market, when a rising tide lifts all boats.
But when markets are choppier and investors become more selective, the positives
of active management tend to shine through.
The performance of U.S. mutual funds underscores the cyclical nature of the active
versus passive debate. One study found that in the five years ending 2017, a mostly
bullish period, index funds that followed the Standard & Poor's 500 Index
outperformed actively-managed funds in Morningstar's large cap blend category for
four out of five years. But in the choppier period from 2000 through 2009, the
actively managed group outperformed the index funds in nine out of ten years.
Navigating a shifting landscape
Of course, no one can say with any certainly which direction markets will take in the
future, or whether active management will outperform passive going forward. But
there are growing signs to indicate that the long bull market that's prevailed for
nearly a decade could give way to more wavering times that magnify the importance
of an active stock selection that adjusts to shifting economic and market conditions.
One concern is valuation. U.S. equity market valuations are at their most expensive
levels in over a decade, and others are catching up. With increases in interest rates,
the economic growth that has buoyed markets could slow down. And it is likely that
the full brunt of protectionist trade policies have yet to be felt.
For investors who want to cover the widest possible range of economic scenarios,
including actively managed funds in the investment mix is a logical strategy. Active
management can be especially effective in global and international investing, where
managers have the freedom to roam a broader investment universe for high quality
companies with growth potential and reasonable valuations.
"As active managers we have the ability to select companies from around the world
with favorable characteristics such as attractive market share, high barriers to
entry, strong cash flows, and low levels of debt. Those attributes have proven to be
valuable to investors, especially in uncertain market environments," says Martin
Connaghan, investment director at Aberdeen's global equities desk in Edinburgh,
Scotland. "Indexing doesn't take into account quality or valuation, and it doesn't
weed out the bad apples."
With hundreds or even thousands of stocks, it's very likely that an index holds at
least one time bomb that could drop precipitously on negative headline news. When
signs of deep problems at a company first start to appear, and well before the press
gets wind of them, active managers have the ability to exit a stock quickly and avoid
potentially devastating blow-ups. Passive indexes can't make such judgment calls or
take such action.
An important part of the investment process at Aberdeen is an environmental,
social, and governance (ESG) assessment that can reveal critical information about a
company's values and practices, as well as potential risks for investors. A growing
body of evidence suggests that when companies are careful to maintain ESG
standards, they are less likely to generate the kind of negative publicity that hurts
Perhaps most importantly, active management at Aberdeen is a forward-thinking
process that takes into account not only on what's going on now, but what may
happen to a company's business in the future under a variety of economic
conditions. Over the long-term, this attention to possible future economic scenarios
and attention to downside protection has the potential to help investors realize
better returns than they could with indexing alone.
The international advantage
Global active managers also have the ability to determine which countries or regions
to emphasize in portfolios based on factors such as market valuation and economic
growth potential. In the U.S., the explosion of domestic exchange-traded funds has
elevated demand for the stocks that appear in their correspondent indices and given
a relatively narrow band of stocks a big say in performance. The top 50 stocks in the
S&P 500 Index, for example, make up 40 percent of that benchmark.
"A lot of stocks in the popular U.S. indexes are overvalued," says Connaghan. "They
are definitely a crowded trade." Many of them, he adds, have been well trodden by
investors and are followed by a swarm of equity analysts.
By contrast, valuations in other areas of the world aren't as expensive. Many of
these companies also tend to receive less coverage from analysts, even though they
have spotless balance sheets and similar clout and recognition at a global level. The
lower profiles of many international stocks, along with their more reasonable
valuations, opens the door to finding "hidden gems" that fly under the radar screens
of most investors.
Managing globally also provides a broader palette of value enhancing strategies for
managers. Just as each country has its unique culture and customs, the investment
and economic climate among countries runs the gamut. Aberdeen's global equity
managers can tailor strategies based on factors such as how the political landscape
might affect certain industries or countries, which markets have the most attractive
valuations and growth prospects, and which companies have the financial stamina
to prosper during both bullish and bearish economic times.
Often, making judicious investment decisions means going against the crowd.
"While we take into consideration what sell-side analysts have to say we are not
satisfied by a majority opinion and we aren't wedded to their recommendations,"
says Connaghan. "Instead, we focus on the potential for change at companies and
where we think the consensus is wrong."
To help ferret out the real story, every company in Aberdeen's equity portfolios has
received at least one personal visit from a company analyst or investment manager.
"Visiting a company and meeting with as many people as possible allows us to get
the whole story, and to assess things that may not be well-understood in the
investment community," says Connaghan. "That's particularly true as you go lower
on the market cap scale or into more unusual geographies."
Headquartered in Aberdeen, Scotland, and with 46 offices in 24 countries, Aberdeen
Standard Investments is uniquely positioned to capitalize on the world's most
promising global opportunities, regardless of where they originate. With $735.5
billion under management, as of June 30, 2018, across diverse asset classes, the
firm delivers original thinking, proprietary research, the highest level of service and
support to thousands of institutional and retail clients.
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Disclaimer â€“ Aberdeen Emerging Markets Equity Income Fund
Pursuant to valuation policies adopted by the Board of Directors of the Fund, the Fund values foreign equity securities that primarily trade in certain markets that close ahead of the Fundâ€™s daily 4:00 pm Eastern net asset value (â€œNAVâ€) calculation time at their fair values using prices provided by third-party independent pricing services. The fair value of each such security generally is calculated by applying a valuation factor provided by the independent pricing service to the last sales price for that security, or, if, the pricing service is unable to provide a fair value for a security, at the price at the close of the exchange on which it is principally traded, subject to adjustment by the Fundâ€™s Pricing Committee. These daily fair valuations seek to reflect information available after the local market close that may affect the value of the foreign equity securities held by the Fund. As a result, this official NAV calculation reflects adjustments that may cause it to vary from a calculation based solely on closing prices. In contrast, the â€œUnadjusted NAVâ€ of the Fund (shown above) is for informational purposes only and is computed using the closing prices on the relevant exchange. It does not reflect any daily fair valuation adjustments of the Fundâ€™s foreign securities. The Unadjusted NAV does not represent the official NAV of the Fund, nor is the Unadjusted NAV used for Fund accounting or performance purposes. Investors should not rely upon the Unadjusted NAV when making their investment decisions.
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Equity stocks of small and mid-cap companies carry greater risk, and more volatility than equity stocks of larger, more established companies.
The use of leverage will also increase market exposure and magnify risk.
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