Increased passive inflows to emerging markets can make outperformance of benchmarks by active managers more difficult in the short term, according to Waverton manager Brook Tellwright.
In its most recent Global Exchange-Traded Product Landscape, BlackRock noted that emerging market equity vehicles had garnered $6.3bn in inflows during the first two months of the year.
Directed towards large-caps with greater liquidity, exchange-traded funds (ETFs) have missed out on the smaller companies with strong fundamentals, says Tellwright.
The manager noted that his fund, Waverton Southeast Asian Focus, had lagged the MSCI ASEAN index during the first quarter, in its latest factsheet. With the benchmark up by 9.4 per cent for the first three months of the year, the offshore fund only rose by 7.2 per cent.
Tellwright and co-manager William Hanbury noted that inflows had surged into emerging markets ETFs during the first quarter, creating “significant distortions in illiquid markets”
They noted: “For instance, around 160 south-east Asian stocks are constituents of the MSCI Emerging Markets index, but we hold only six of those accounting for 25 per cent of NAV.
“As a result, when emerging market ETFs are ‘hot’, large-cap stocks will outperform our ‘below the radar’ holdings.”
Performance of fund vs index during Q1 2017
Source: FE Analytics
While the impact of increased passive investment into the emerging markets and the south-east Asian stocks the fund invests in can harm returns in the short-term, Tellwright says there are opportunities in other parts of the market.
He said: “We tend to invest over a very long time horizon of three-to-five years. We look at companies and try to understand what the earnings potential is over [that] time horizon.”
“We can add value as an active manager in Asia. I think a lot the peer group have very much a short-term horizon and are looking at a one-year perspective.”
Indeed, the manager argues that inefficiencies have arisen in emerging markets more recently as more passive money has flowed to the sector.
He says some of the bigger players active in the south-east Asian market operate as “quasi-index funds” that are restricted to large-cap stocks by their size and in effect end up replicating the index.
From a universe of around 4,000 listed stocks, the manager says through screens this is reduced to an investable universe of 550 before further being whittled down to a watch list of 100 companies. From the watch list, Tellwright says the fund creates a highly concentrated portfolio with a maximum of 30 stocks.
“We’re small and nimble, we will not grow above $500m,” he said. “We’re determined to maintain the ability to own mid-caps where we see value and never invest in more than 30 stocks. We’ll always be a best ideas, stockpicking fund.”
The manager says the team is flexible on valuations and is contrarian in its approach, preferring to focus on reasonable prices.
There are five key attributes the managers looks for, according to Tellwright: aligned interests with minority shareholders, earnings visibility, pricing power, cash generative companies and those with a return on capital.
The manager says while the fund is not theme-driven it nevertheless aims to take opportunities presented by the changing demographics in the region, including the emergence of a growing middle class with greater discretionary spending power.
“We’ve seen over the past half-century many ASEAN countries and economies going through the process,” he said. “It began in Japan, Taiwan, South Korea, Hong Kong and Singapore. We know what sectors and companies do well.”
Tellwright added: “We don’t have a sector bias… we’re much more geared towards domestic demand than export sectors.
“These are still export-led economies by and large but we want to find companies that can really gain from the growth of the middle classes.”
Indeed, the fund’s largest overweight sector is the consumer discretionary sector, representing a 17.1 per cent weight in the portfolio at the end of the first quarter. However, the largest sector weighting was financials representing 19.4 per cent of the fund’s holdings.
Over three years the fund has returned 32.82 per cent, compared with a 26.53 per cent gain in the index. The average FCA Recognised offshore fund in the Asia Pacific ex-Japan sector was up by 45.59 per cent in comparison.
Performance of fund vs benchmark & sector over 3yrs
Source: FE Analytics
The fund has an ongoing charge figure (OCF) of 2.11 per cent. It also carries a 3 per cent entry charge and a 10 per cent performance fee on returns above the benchmark subject to losses of previous years being recovered, according to the fund’s key investor information document (KIID).