The current investment backdrop provides a unique opportunity for investors to buy into emerging markets with “widespread fear” from the market over US president Donald Trump’s potential trade war.
But investors need to think carefully about how to invest, with genuine active management key in the face of the rise of passive vehicles which has exposed funds that are ‘closet-indexers’.
As such, veteran investor Mark Mobius, formerly of asset manager Franklin Templeton, is to launch a new emerging market investment trust next week.
The trust will invest in 25 to 30 names of mid- and small-cap names that are typically not in the MSCI Emerging Markets benchmark.
“The growth of passive funds has had an incredible impact on our business and one of the reasons we decided to set up on our own was in reaction to that because we saw the handwriting on the wall,” Mobius said.
“Active fund managers in big firms are really challenged. We were all sort of closet-indexing. We were looking at the index and comparing each week.
“Active managers have had to become really active, which is why we’ve decided to do what we are doing as that is where the value-add is going to be.”
The rise of passives can be viewed as a positive for active managers, he said, despite the average fund in the IA Global Emerging Markets sector underperforming the MSCI Emerging Markets index over one, three five and 10 years.
Performance of sector vs index over 10yrs
Source: FE Analytics
Mobius said: “When there is volatility all of the index strategies must follow the same pattern, they must all be selling at the same time and you have this snowball effect.
“You can have huge stocks falling by 5 per cent in one day as the machines are working. That gives opportunities for the active managers.”
His new trust, however, will likely focus more on companies outside of the index with a skew to quality names with strong managements that have continued to grow and shown the ability to innovate over time.
While there are roughly 950 stocks in the MSCI Global Emerging Markets index for example, there are another 14,000 companies outside which are typically not held by other large funds and trusts.
“The large list of funds and trusts have become too big and often have exposure to the same names and emerging market champions,” fellow Mobius Capital Partners’ fund manager Carlos Hardenberg added.
“There is this bad habit of trying to be as close as possible to the index but still look different.”
As such, now is the right time to be launching such a strategy, he said, with widespread fear over US president Trump’s next move despite the political risk shifting from the emerging to the developed world.
“There is a big fear about the £300bn in tariffs from the US against the Chinese and there is also a fear about the strengthening US dollar as well as commodity prices strengthening and we have seen the market has reacted strongly,” Hardenberg said.
“I wouldn’t yet call it ‘blood on the streets’ but in certain areas we are close to it. There is a huge degree of pessimism baked into prices.”
One area where this has been felt hardest is in the currency markets, with the Turkish lira down 90 per cent, the Brazilian real losing nearly 60 per cent, Mexican peso almost 40 per cent lower.
These currencies, along with Argentina’s peso and South African rand (among a long list of others) have all corrected rapidly and are bordering on “overshooting territory”.
“If you look at the fundamentals, these countries had huge deficits, fiscal problems, loads of foreign currency debt and no foreign exchange reserves – so they had multiple problems,” the manager said.
“If you look at today most of them are at surplus and 90 per cent of emerging market countries have a current account deficit of less than 1 per cent.”
Countries are also exhibiting more fiscal discipline, accumulating their largest ever stock of foreign currency reserves. All this combined suggests that they are well prepared to deal with this volatility, he noted.
“When we look back at this time in two-to-three years we will see that this is a unique time to get exposure to these vibrant economies and underlying companies,” Hardenberg said.
Yet this fear has also fed into markets, where the overall emerging market book values and price-to-earnings multiples (P/Es) are at a 12-year low.
Perhaps the best example of this is Mexico, which was hit hard when Trump was elected president in November 2016 and has struggled again this year on the back of trade concerns.
Performance of index since US election in local currency
Source: FE Analytics
“When Trump was talking about the wall, this mountain of pessimism started growing into nirvana and there were expectations that the mobile industry would no longer operate, there would be no free trade and that they would force foreign companies to sell their assets in Mexico,” Hardenberg said.
“This was almost accepted as a fact and it was all complete rubbish. They renegotiated NAFTA [North America Free Trade Agreement] which is now going to be very helpful for Mexico. They have free trade access to the US market and still a very preferential deal with the US.”
Mobius (pictured) added that he doesn’t believe that the fears of a trade war between president Trump and China will be as detrimental as investors are fearing. 
The veteran investor said: “They will negotiate. The Chinese are long-term thinkers and the Americans are short-term thinkers and this will gel and works well.”
While there will be some short-term pain felt, he added that this will lead to market dislocation, which should in turn provide winners and losers for active managers like themselves to take advantage of.
So, what can you expect to see in the new Mobius Capital Partners investment trust when it comes to market?
“The first thing you will notice from the portfolio is that we are going into markets that are performing badly and are down substantially,” Mobius said.
In the current model portfolios, he highlighted that there is some exposure to Turkey – although not a lot – while China (which dominates the index) is a much lower weighting that investors may expect.
“Brazil is in there as well, so you will find a lot of countries in there that you normally wouldn’t expect to be but where we are finding terrific opportunities,” he said.
At a sector level, the team are interested in healthcare and education stocks, which they believe offer attractive opportunities on a five-to-10 year time horizon despite being small sectors of the market. Perhaps the major theme throughout the portfolio, however, will be technology.
“Although we are not going to be in the Alibaba or Tencent companies, we are going to be in traditional industries that are being impacted by technology and adopting it in their businesses,” the manager said.
The managers will also invest up to 20 per cent in frontier markets, which Hardenberg said “is a very important part of a properly diversified emerging market portfolio”.
“We have never understood the differentiation between emerging and frontier – there is no good reason you shouldn’t look at both,” he explained. “Frontier markets are growing even faster, they have much more political stability than ever before and they are developing their capital markets quickly.”
The trust will be managed by with an ESG (environmental, social & governance) blueprint although to start with the main focus will be on governance.
“Unless you fix governance you are not going to get anywhere with the environment and social aspects,” Mobius said.
To keep it focused, the overall strategy will likely have a maximum ceiling of assets under management (AUM) of $1.4bn and investors backing the launch will be given the option to sell their shares back to the company after four years.
The board will implement a share buyback mechanism, which will aim to limit the discount of the investment trust to 5 per cent barring any significant shifts in the market.