Why your defensive emerging markets fund has “had its time in the sun”

The emerging market funds that prospered in the post-crisis period thanks their defensive nature might not be the most attractive – or safest – strategies from here.

That’s the view of Neptune head of emerging market equities Ewan Thompson, who believes it might be time to move on from the defensive-style funds that investors have relied on in recent years.

FE Analytics shows that the MSCI Emerging Markets index fell 17.16 per cent between October 2010 and January 2016, massively underperforming the MSCI World which posted a 57.95 per cent gain. Those investors that did invest in emerging markets tended to pour money into the funds invested in the ‘safer’ areas of the market.

Thompson said: “Between 2011 to 2015, you have slowing global growth led by China and you’ve got a hunt for bond proxy type stocks.”

Source: FE Analytics

This search for so-called ‘bond proxies’ – or companies with decent growth and solid dividends – is reflected in the chart above. The three emerging market sectors in blue are populated with this type of stock and their relative returns are much higher than the MSCI Emerging Markets index; the more cyclical sectors, in red, underperformed the broader market.

This outperformance bid up the valuation of the more defensive sectors, but owning funds with a bias to these areas paid off during this period. Thompson said: “The only reason to own those stocks is because you’re worried. You’re paying a premium for protection because you have no idea what the world is going to do.

“During that period, 2011-2015, every time the market fell, the funds that had the highest P/E ratio –  the most expensive funds – performed the best.”

FE Analytics shows that between October 2010 and January 2016 the 10 funds with the highest exposure to emerging market consumer staples stocks, for example, were less volatile and had a lower maximum drawdown than their average IA Global Emerging Markets peer. However, Thompson expects this dynamic to change.

When emerging markets started to show a run of form in 2016, Neptune’s Thompson largely attributed this to reversing fortunes for the asset classes with the wind now fully behind the developing world.

Sustained economic growth appeared in the major emerging markets and the closure of current account deficits in Brazil, India and South Africa meant they were better prepared to deal with the rate hikes in the US, he explained.

According to FE Analytics, the MSCI Emerging Markets index outperformed the MSCI World in the period between January 2016 and March 2018 by 30 percentage points. In the same period, Brazil and Russia, two countries that have historically seen worse returns than the index, both outperformed the MSCI Emerging Markets.

Thompson said: “That’s the holy trinity of low valuations, improving fundamentals and people don’t own [emerging markets] means that, that’s a much more defensive place to be than over owned, expensive and fundamentals deteriorating.”

Source: FE Analytics

The reversal of fortunes in emerging markets is accompanied by a reversal in fortunes for those invested in the cyclical-focused funds. The above chart demonstrates a U-turn in sector performance with economically-sensitive sectors such as energy and materials winning higher relative returns and defensive sectors falling below the MSCI Emerging Markets index.

While defensive emerging market funds tended to outperform up to 2016 thanks to their bias to areas, Thompson argued that the current conditions being seen in the asset class will lead them to struggle.

“A lot of these funds, that’s their mandate and that’s exactly what they should be doing,” he added. “Our point would be, they’ve had their time in the sun.”

Thompson remarked that these funds are now underperforming with increased volatility thanks to the lofty valuations in areas such as consumer staples: “I think risk is far more in those expensive stocks. Their earnings are under pressure, they’ve got nowhere to hide. The only thing they’ve got going for them is price stability.

“Yet, suddenly when the market gets volatile these stocks are selling off more than the market. Suddenly, you’re paying a very high price, earnings momentum is long ago faded, and you’ve got price volatility, exactly the thing you’re paying not to have.”

Defensive sectors like consumer staples that previously displayed some of the lowest downside capture in emerging markets have, since January 2016, not been able to protect as well against falls in the market while also capturing less of the upside. Inversely, energy reduced its downside capture from 117.71 per cent to 83.22 per cent and increased its upside capture from 99.79 per cent to 111.97 per cent.

Monthly upside and downside capture of emerging market sectors

Source: FE Analytics

Thompson’s own fund, Neptune Emerging Markets, is testament to the changing tides in emerging markets, being overweight in cyclical sectors including financials, materials and technology while investing in economically-sensitive regions such as Russia and Brazil. Although the fund slightly underperformed the benchmark between January 2016 and March 2018, it fared better than its average peer by 6.18 percentage points.

One thing that struck the fund manager was that money is still pouring into the same defensive-style funds.

He said: “What’s interesting is the flows are continually going into the same funds they went into in 2015, they’re underperforming with massively increased volatility. When you’re getting much more volatility and you’re underperforming and going down more than the market, that feels like a bit of a wakeup call.”

“If I’m right on this emerging markets story, you’ve got to change your portfolio from 2015 to 2018. Things are totally different in the world.”

Adrian Lowcock, investment director at Architas, noted that emerging markets have experienced a tailwind from the weaker US dollar but continues to face an overhang from a potential global trade war. That said, he added that the area still looks to be an interesting one.

“Emerging markets railed strongly last year but should continue to offer investors opportunities as the asset class benefits from the global growth and tends to run multiple years of bull markets,” he said.