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Is now the time to go active in emerging markets?

01 February 2018

Managers consider whether investors should continue to back passive vehicles or move into active funds for their emerging market exposure.

By Jonathan Jones,

Senior Reporter, FE Trustnet

While cash has flowed into passive emerging market products as active strategies have underperformed, investors might be missing out on interesting opportunities outside of the benchmark, according to Jupiter’s Ross Teverson.

A trend towards passive products in recent years has been witnessed across the broader industry but opinion has been divided in the emerging markets space.

Some advisers prefer to use active strategies for emerging markets, arguing that the inefficient nature of the market gives them more scope to outperform.

Indeed, with more stocks, many individual countries to choose from and less research going into the region, it stands to reason that active managers should have a better chance to outperform.

Yet, the MSCI Emerging Markets index has outperformed the average IA Global Emerging Market fund over 10 years by 16.37 percentage points. Only around two-fifths of funds outperformed the index over the period.

Performance of sector vs index over 10yrs

Source: FE Analytics

Peter Sleep, senior investment manager, at Seven Investment Management (7IM), said: “There is a school of thought that emerging markets equity should be easier for active managers because they are less efficient.

“However, the average emerging markets equity manager has shown that this is not the case – they have been whipsawed by several factors which have had a big impact on the entire asset class.”

One factor has been the rise and subsequent collapse in the oil price and other commodities which have had a big impact on the entire region.

“Not only that but they have had to get right their calls on big index names like Samsung and the Chinese internet companies like Tencent,” Sleep added.

“Many investors have found it difficult to find active asset managers in the emerging market equity region and have preferred to go passive.”

As such, it should be no surprise that since exchange-traded funds (ETFs) have grown in popularity and over the last two years have dominated the net inflows.

Teverson, who manages the four FE Crown-rated Jupiter Global Emerging Markets fund, said ETFs have become an increasingly important source of flows into emerging markets in recent years.

He said that over two years there had been positive net flows into emerging market equity fund had been dominated by cash pouring into ETFs, as the below chart shows.

Source: Jupiter Asset Management

“Last year 80 per cent of [inflows] – so £52bn – was in the form of ETF net flows into emerging markets and in 2016 almost the entire net inflows into emerging markets was explainable by ETFs,” said Teverson (pictured).

“When there is so much going into ETFs we want to emphasise the benefits to long-term investors of looking more broadly than just the index and having a multi-cap exposure.”

The Jupiter manager highlighted the inefficient nature of the market and the potential to pick up interesting companies at good valuations outside of the benchmark that would not be on a passive strategy’s radar.

“I find it surprising that investors are so keen to access emerging markets through an ETF when the opportunities to generate alpha through stockpicking and the opportunities to invest outside of that index are really quite compelling,” Teverson said.

One area is Chinese banks, which are cheap stocks with large market capitalisations. While at a headline level the stocks look attractive, the manager said there are underlying reasons to avoid stocks that would not be picked up by a passive fund.

“Agricultural Bank of China is a good example of a stock that appears cheap as its shares are valued around 6x earnings with a 4 per cent dividend yield,” he said.

“On face value that is attractive but actually we believe it is cheap for a good reason. If you look at the level of indebtedness in China, there is debt-to-GDP of close to 270 per cent.

“A lot of the growth in debt has been driven by corporate debt and that is a risk the banks will be exposed to.”

As such, any potential for rising interest rates or a slowdown in growth could lead to defaults, causing balance sheet problems for these banks.

The bank is what Teverson describes as a ‘cheap for a reason’ stock represented on the chart below, which shows the investable universe of his fund. All those above the dotted line are included in the MSCI Emerging Markets index, while those below are not.

Source: Jupiter Asset Management

At the other end of the spectrum is what the manager describes as ‘crowded quality’ where companies with quality characteristics have been bid up for their attractive, stable returns.

“Large-cap quality stocks and businesses that have a very secure business model have become expensive in our view,” he said.

Here, he used the example of Hindustan Unilever, a subsidiary of the FTSE 100 giant, which is listed on the Indian stock exchange.

“I would not deny that it is a good company with good long-term growth prospects selling household products into a growing Indian market but once you are paying over 50x earnings for a company that is currently growing its revenue at about 12 per cent year-on-year, that in our view is a stable company that has become a risky investment because its valuation is so high,” he said.

“[Therefore] I think it is more important now than ever to talk about the benefits of having active input in the investment process when so much of the market is going into ETFs, which are blindly investing in equities.”

Damian Barry, senior investment manager of the multi-manager range at 7IM, agreed noting that he has not been invested in passive emerging markets equity strategies in recent memory.

“We would not disagree that the average manager has disappointed, that is why we spend so much time and energy trying to find managers that we believe are above average in insights and ability,” he said.

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