Early and Often; the Approach to Long-term Returns in Emerging Markets
June 3, 2014
Early and Often; the Approach to Returns in Emerging Markets
In November 2010 we launched the first fund in Canada focused on dividend paying equities in the Emerging Markets. After examining the competitive landscape and seeing the global trend towards emerging market debt, we decided that the long-term opportunity for Canadians in the EM space was investing in lower volatility, cash generative businesses.
Our search began to find a portfolio manager with a depth of experience in this space. It became obvious that the approach was indeed fairly novel and very new – after 100 years of dividend investing in developed markets, this age-old approach was a new trend for EM.
Our search for investment managers narrowed very quickly to four companies. It became clear that after only three years in business, Somerset Capital Management stood out for a number of reasons.
Somerset was set up to be a specialist firm in the space. Emerging markets equity investing was not a part of their business; it was the entirety of their business. This benefits clients through a depth of knowledge, focus and continuity of personnel and fund managers, that is not often duplicated at large conglomerates.
Despite the corporate structure of the firm being young, the investment team was formidable. The nucleus of which had been investing in the Emerging Markets, together at another firm, since the early 1990’s, when only a few investors seemed to be making trips to places like Russia and Brazil looking for investment ideas.
The firm has also organized itself as a partnership, a structure that ensures employees have a stake in the business and most importantly, that their interests are aligned with their clients.
The first Emerging Markets fund was launched in 1986. In a recent Wall Street Journal article, they quote an early fund manager as saying, “I’m not sure if I’m making an investment or a donation” to a fund that was organized in 1986 and managed by Capital Group. The first retail fund followed a year later with Templeton launching their Emerging Markets fund in 1987.
For the first few years of investing in Emerging Markets, clients enjoyed spectacular returns, the 5 year return to December 31, 1993 averaged 36%. Due to these returns, the number of products proliferated and assets of almost $6b entered the EM space in 1993 alone. As it always seems to happen, people invested just in time for what proved to be a terrible 5 years. From 1994 to the end of 1998, EM funds delivered compound return of -11%, with a -28% return in 1998.
In Canada, the Emerging Market fund category had less than $1 billion in assets in 2002. By the time Canadians started to ever so slightly allocate towards emerging markets in 2006, the MSCI World Index had moved from ~270 to over 700. It had almost doubled again by October 2007.
Post 2007, the cycle repeated itself again as a combination of poor returns and investor redemptions saw assets halved. 2011, was a similar story with the assets that Canadians had in EM reduced by about one third.
In fact, if you were to look at the boom and bust cycles of emerging markets, both from a return and asset perspective you will have seen the boom-bust scenario play out in 1990, 1994,1997, 2000, 2007, 2008 and 2011.
Investors who were able to stomach that volatility would have made 10 times their money since 1987, however we know that dollar weighted returns are likely far lower.
In the 41 months since we launched the Redwood Emerging Markets Dividend Fund, almost $200 million has come out of the space in the way of net redemptions, and total assets in Canadian EM has dropped 30% from $5.5 billion to $4 billion.
These figures parallel what has happened globally, as the allocation by institutions has largely been away from the EM space. Despite representing 30% of world GDP, allocations in even the most forward thinking institutions are below 10%.
Year-to-date however things are starting to change. As relative valuations in EM have gotten more attractive, and a number of EM economies appear to be going through bottoming processes (ie. Economic stats going from less bad to better) there has been a renewed interest in investing in EM.
The iShares and Vanguard Emerging Market ETFs are bringing in significant assets, and institutions are also beginning to re-allocate.
The chorus of strategists are also starting to build in their support of investing in the Emerging Markets.
For those looking to invest in Emerging Markets, we believe a dividend approach reduces volatility and focuses on companies with good governance, respect for the shareholder and solid business fundamentals.
Here are our beliefs
- Invest early, and dollar-cost average
- Volatility will be prevalent. Unless you’re picking a bottom, consider spreading your investment out over a few months or quarters.
- For Canadians; get diversification
- Many EM strategies have exposure to many of the same economic levers that power the Canadian economy and lead to gains in natural resources. Be aware of your exposures.
- Avoid ‘credit stories’
- Our belief is that credit will be less available in the coming years, companies who benefit from loose credit will not be the leaders going forward
- Moving away from domestic consumption stories
- Companies benefitting from domestic consumption was an excellent investment theme, however these stories have gotten much more complex due to currency.
- Actively manage currency – currency wars continue
- As above, the currency wars will continue in emerging markets, and complicate the economics of companies and countries that import many of their goods.