a subsidiary of Purpose Investments Inc.

Challenges in the current Emerging Markets bull market

By Edward Lam, Lead Fund Manager

 

The market continues to be well supported. For 12 months now, month after month and with little pause, I have done my best to argue the idea that emerging markets have started on a new bull-market journey. I see no reason to stop. There was once an idea put about that I was a permanent bear. So much for that.

As I suggested 12 months ago, it takes a long time to turn around the mind-set of the marketplace. There is still a lot of resistance to the optimists’ view and a few persistent myths: rising U.S. rates are bad for emerging markets; a larger fiscal deficit implies a stronger dollar; a stronger dollar is bad for emerging markets. Whilst it is too strong to say that none of this is true, the naïve historian will beat the sophisticated economist to the punch by simply observing 2003 to 2006. There are also new illusions: Trump is bad for emerging markets. I maintain my view (President-Elect Trump: Good or Bad for Emerging Markets?)

Something that is more problematic: how to invest in these markets?

We have barely kept up. There are pros and cons to different funds, different managers and different instruments. My advice to the generalist is not to be too clever. If you are already invested there is no need to trade around the position; just add selectively where you need to. If you have suddenly changed your mind and you feel underinvested, don’t act as if that is the case. Move gradually towards a policy position over time. In either case, there is no sense in trusting completely to a single vehicle or instrument. Judicious diversification is beneficial. If you go for an indexing or smart beta methodology, please pay as much attention to the reliability of the manager and the construction methodology as you would if you were choosing an ‘active’ manager.

I have elsewhere documented the example of ‘HILO US’² (a high-dividend, low-volatility emerging market exchange traded smart beta fund strategy) that changed its index after a period of disappointing performance. Performance has not significantly improved. One of the major question marks against the emerging markets as an asset class is the complexity and disparate nature of this collection of markets, but this is no less of a mark against an attempt at indexing the market itself as against actively managing against the market within the basket. The S&P 500 is simpler; and the MSCI EM index has the benefit of transparency, even if it is inefficient.

Likewise, I observe as much for my own benefit that in these sorts of markets it may not pay to be too fastidious about the fundamentals. Companies (such as restructurers like Eurocash) or markets (like South Africa, which is in the middle of a downgrade) that have problems are unlikely to perform in the short term. However, in companies and markets where fundamentals are fine, capital flows are likely to drive as much of the performance as the fundamentals.

Just as U.S. active managers have had to contend with a narrow portion of the market driving a large part of the returns (FANG), emerging managers will likely have to contend with a similar problem (STTIR? HTTPS?2  ̶  someone will come up with a better acronym than me). This is the point at which the capitalisation-weighted index comes into its own.

 

1 See also c.f. Investment Adviser magazine issue, 10th April 2017, “Due Diligence Conundrum over Smart Beta fund labels”.

2 Samsung, TSMC, Tencent, Itau, Reliance; Hang Seng Bank, Tencent, TSMC, Petrobras, Samsung.

 

 

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