Investors are wrong to blindly invest in index tracker and exchange traded funds (ETFs) for their emerging market exposure, according to Simon Pickard and Edward Cole, who say a strategy of simply buying the market is fraught with risk.
FE Trustnet has written, on a number of occasions, how the ‘average’ active fund in the IA Global Emerging Markets sector has consistently struggled relative to the MSCI Emerging Markets index over nearly all time frames.
According to FE Analytics, the sector average is underperforming the index over one, three, five and 10 years and has only beaten it in three out of the last 10 calendar years.
Performance of sector versus index over 10yrs
Source: FE Analytics
On top of that, just 11 per cent of the peer group’s current constituents have managed to outperform the benchmark on a decade-long view.
This trend has led to a huge increase in popularity for trackers and ETFs.
According to FE Analytics, three of the top 10 selling funds in the sector over the past year have been trackers while the likes of the Vanguard Emerging Markets Stock Index, which has a FE Passive Fund Rating of 5, has (up until the recent sell-off) seen its AUM surge by more than 60 per cent over three years despite the index’s losses over that time.
In addition, many multi-managers (such as Mark Harris at City Financial) are planning on using trackers to give them quick, easy and cheap access to a possible rally in emerging markets.
However Pickard and Cole, who used to run the Carmignac Emergents fund but are soon to launch their new Man GLG Unconstrained Emerging Equity fund, say simply buying the index is fraught with risk at this point in time.
“There are two reasons –a country reason and a stock reason,” Cole said.
“First is at a country level you have massive variation in the amount of leverage in emerging market economies. The last six years of ultra-easy monetary policy has created a lot of leverage and what a lot of emerging markets have done is they have fuelled their credit growth by borrowing abroad.”
“We don’t know, but we would say that over the next three years the sustainability which has fuelled that sort of credit growth won’t continue. If you buy an ETF, you end up holding a lot of countries that have basically got too much leverage. You have to distinguish between countries which can fund themselves and those that can’t.”
He points out it is a similar situation at a stock level, highlighting that the majority of companies within the index have borrowed heavily and most of that debt is in dollars – which would cause major issues if flows into emerging markets were to decline further.
“There is an awful lot of the benchmark which has done that. Petrobras is basically a tower of debt. I don’t want to be exposed to that. Yes, if you can call tactical rallies like that last three months then buying an ETF makes a lot of sense. But I can’t do that and I don’t think many people can.”
That being said, the index has rallied hard recently following the events of ‘Black Monday’ in late August when fears of a ‘hard landing’ in the Chinese economy caused global stock markets to fall in tandem.
According to FE Analytics, it is up some 15.33 per cent and only 19 per cent of funds have managed to outperform the benchmark over that time.
Performance of sector versus index since ‘Black Monday’
Source: FE Analytics
However, Cole says this rally (like in other indices around the world) is technical in its nature as it has been led by some of the index’s largest, worst quality names which had been hit very hard during market falls prior to ‘Black Monday’.
“Things got very extreme in terms of capitulatory price action and it was one way traffic for three months. We have an indicator that shows this, the market capitulates on emerging markets,” Cole said.
Pickard notes there are other fundamental risks at a corporate level which should dissuade investors from buying the index.
“There are other quite worrying things going on. First is the deflationary indicators have been flashing and the second concern is that the MSCI Emerging Markets index has been trading over fair value for the current liquidity conditions,” he said.
“Whilst you still have those two things going on – poor liquidity conditions and no evidence that sales growth is giving you the operational boost you want – I think that investing in ‘the market’, apart from picking a three-month rally, is the wrong idea and you really want to be stock picking.”
Of course, it will come as little surprise to investors that active managers believe active funds are the best way forward.
Cole admits that, as a group, active managers within the IA Global Emerging Markets sector have given a particularly poor showing over the longer term. However, he says there is one major reason why the sector average has failed to beat the index on a consistent basis.
“Genuinely, I think there are a lot of managers who aren’t proper stock pickers. I think there is a massive amount of closet tracking going on. If you look at active share numbers and tracking error numbers, there are people running big emerging market funds who have tracking error of 3 per cent,” Cole said.
“How can you ever outperform if you start by looking at what everyone else is looking at? It’s mathematically impossible. I’m not saying these are easy markets at all, but I think the general trend has been that people aren’t taking a lot of risk and that most a benchmark huggers.”
According to FE Analytics, there are 10 funds in the sector that have had a tracking error relative to the MSCI Emerging Markets index of less than 5 per cent over five years.
Four of them have beaten the index over that time though – namely Candriam Equities Emerging Markets, GS Growth & Emerging Markets Broad Equity, Candriam Equities Sustainable Emerging Markets and Schroder Global Emerging Markets.
Source: FE Analytics
Cole and Pickard, though, are looking to take a far more active approach in their soon to be launched Man GLG fund.
It is designed to be a concentrated portfolio of around 50 stocks and the managers are aiming for a high tracking error but low active share. The process they will use is based around the idea of high quality companies at a reasonable price.
In fact, it is the same process the managers used on their old Carmignac Emergents fund which outperformed both the index and the sector during Pickard’s tenure between September 2008 and February 2015.
Performance of fund versus sector and index under Pickard
Source: FE Analytics
It also had the sector’s fourth highest tracking error, was top decile for its alpha generation relative to the benchmark and its risk-adjusted returns, and had the lowest maximum drawdown.
Pickard is hoping for a similar performance profile from Man GLG Unconstrained Emerging Equity, albeit with higher returns as he isn’t constrained by his old fund's charging system – which meant his old OCF was consistently higher than 2 per cent.
It does seem an odd time to launch an emerging markets fund at this point and is certainly against the grain, given the depressed sentiment towards the developing world.
They agree it might seem fairly contrarian. However, the two managers are constructive and between them own 10 per cent of the fund’s current AUM. The major reason they are positive is valuation.
“Both of us have money in the fund and I'm a lot, lot happier putting money into it as of August rather June 2013. Both of us want to do this for the next 15 to 20 years but prospective investors are probably thinking over the next three years and yes, I do think now is the time to buy emerging markets.”
"In terms of cyclically adjusted P/E ratios, emerging markets are now trading at six times which is the lowest level since 1992. The US, on the other hand, is on 22 times. If you are thinking about money making opportunities over the next 10 years, then it is probably emerging markets rather than developed markets."
