Download Active Management and Emerging Markets Equities

ACTIVE MANAGEMENT
AND EMERGING
MARKETS EQUITIES
Together They Work
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Active Management and Emerging Markets Equities: Together They Work | 1
Introduction
One important consideration investors have with regard to emerging markets (EM) investing
is whether to employ active or passive management. In this paper we take a closer look at
some of the fundamental challenges particular to EM and how active management helps
overcome them.
Consider that since investment managers make up the market, they cannot in aggregate beat
the market. The active industry, it is argued, will underperform a market index because of
the aggregate excess fees it charges. In our view, such arguments miss the point. What is
important is not so much what active managers do in aggregate, but the conditions under
which it makes sense to pursue active management and why active management is even
more important in EM. There are several reasons why experienced investors should consider
an actively managed portfolio when choosing an allocation to emerging market equities.
The importance of thorough
manager due diligence by
advisors and investors can’t
be overstated in the effort to
find active managers who can
be expected to outperform the
benchmark over time.
Active Managers Can
Outperform in EM
• During the last fifteen years active managers in EM have generated a rolling 5-year excess return over the MSCI
Emerging Markets Index of more than 200 bps. An excess return is maintained even after paying management fees.*
• Outperformance over the MSCI Emerging Markets Index and passive funds may be obtained with less risk and
volatility.
• The top tercile of active money managers have exhibited consistency in generating excess returns – outperforming
benchmark and peers approximately 70% of the time over the past three years (see Exhibit 4).
• Truly active fund managers, defined as those with an active share above 70%, have a better chance to outperform
over time.
Going Active Makes
Sense if Markets
Are Inefficient
• The EM universe is very large and there are a large number of stocks with little or no coverage at all. For example,
there are three times more stocks listed collectively in Brazil, Russia, India and China (BRIC) than there are in the
U.S., yet there are three times fewer analysts covering these stocks.
• As a result of lower research coverage, the accuracy in forecasting earnings and returns is much lower than in
developed markets (DM) which increases opportunities for fundamental analysis to exploit market inefficiencies.
Portfolio Needs to
be Selective in EM
• Focus on quality is very important in EM as there are many companies with poor corporate governance.
• Approximately 30% of the benchmark for EM equities is comprised of large state owned enterprises (SOEs) whose
profits may be used for social purposes at the detriment of profitability and equity performance. These companies
have underperformed private companies and the MSCI Emerging Markets Index by approximately 80% and 30%,
respectively.**
• Investors buying exchange traded funds (ETFs) will inevitably invest in these private companies.
Benchmark Is a
Poor Reflection
of EM Universe
Opportunities
• There are almost 10,000 companies listed in EM and only 836 stocks in the MSCI Emerging Markets Index, of which
674 are mega or large caps.
• EM small caps and frontier market stocks are considered inefficient and are generally excluded from passive
strategies.
• The MSCI Emerging Markets Index is biased towards large state owned companies.
Active Investments
in EM Are ESG
Compatible
• The analysis of environmental, social and governance (ESG) is particularly important in EM. This is because while
there is a lack of comprehensive research coverage in EM in general, there is a dearth of ESG related analysis in
particular. This makes the bottom up analysis of money managers in this area increasingly important.
• Excluding or favoring securities on the basis of ESG criteria involves deviating from the benchmark, which leads to
higher tracking error and may work as a defeating argument for passive investments.
*Based on average annual management fee of 88 bps for active EM managers. Source: Fee Survey 2014, Mercer
**Source: UBS, February 2015
Active managers rely on analytical research, forecasts, and their own judgment and experience in making investment decisions on what securities to buy, hold and sell.
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2 | Active Management and Emerging Markets Equities: Together They Work
EXHIBIT 1
(Truly) Active Managers
Outperform in Emerging
Markets
Rolling 5-Year Excess Return of Active EM Equity Managers vs.
MSCI Emerging Markets Index1
8.0%
7.0%
6.0%
5.0%
4.0%
Top Quartile
3.0%
As Exhibit 1 illustrates, evidence suggests that active
managers in EM have outperformed over time and based on
our analysis, they have done so with less risk and volatility.
2.0%
1.0%
0.0%
-1.0%
-2.0%
Median of EM Managers
3/14
9/14
6/13
9/12
3/11
12/11
6/10
9/09
3/08
12/08
6/07
9/06
3/05
12/05
6/04
9/03
3/02
MSCI Emerging
Markets Index
12/02
6/01
9/00
12/99
-3.0%
Bottom Quartile
Top & Bottom Quartiles
of EM Managers
Source: Mercer Manager Performance Analytics, September 2014
EXHIBIT 2
Sharpe Ratio—Active vs. Passive
0.8%
0.6%
0.4%
0.2%
0.0%
-0.2%
1 Year
3 Years
Top Quartile EM Managers
Emerging Markets Equity Universe
5 Years
Bottom Quartile EM Managers
iShares EM ETF
Source: Mercer Manager Performance Analytics. Performance characteristics in USD
(before fees) over 1-, 3- and 5-years ending December 2014 (monthly calculations).
EXHIBIT 3
The median EM active managers have generated, on average,
a rolling 5-year excess return of more than 200 basis points
(bps) versus the MSCI Emerging Markets Index in U.S. dollars
over the past 15 years ending September 2014. Assuming
an average management fee of 88 bps, these returns are
also maintained net of fees. These returns boast superior
risk characteristics compared to the performance generated
by their passive counterparts. In fact, the universe of EM
active managers analyzed (based on the Mercer Database
of EM active managers) reveal a better risk/return ratio,
as demonstrated by their higher Sharpe ratio, and also
lower overall volatility than passive strategies. As Exhibit
2 illustrates, the average Sharpe ratio for active EM active
managers is higher than the iShares EM ETF, one of the largest
EM passive strategies.
By the same token, the volatility of top quartile EM managers’
portfolio returns is lower than those of the iShare EM ETF
(Exhibit 3). Furthermore, research shows a remarkable
degree of consistency in the excess return generated by the
top EM portfolio managers. The key attributes necessary to
outperform are a high active share–basically the portfolio
needs to differ from the benchmark–and a strong and
replicable investment process. The lack of one or the other
may lead to underperformance or the “mortality” of the
manager in the long run. Those EM active managers with a
strong investment process which gives them confidence to
implement “active bets” seem to perform with a very high
degree of consistency suggesting that a strong investment
Volatility—Active vs. Passive
25%
20%
15%
10%
5%
0%
1 Year
3 Years
Top Quartile EM Managers
Emerging Markets Equity Universe
5 Years
Bottom Quartile EM Managers
iShares EM ETF
Source: Mercer Manager Performance Analytics. Performance characteristics in USD
(before fees) over 1-, 3- and 5-years ending December 2014 (monthly calculations).
The MSCI Emerging Markets Index was launched on January 1, 2001.
Data prior to the launch date is back-tested data provided by MSCI (i.e.,
calculations of how the index might have performed over that time period
had the index existed.) There are frequently material differences between
back-tested performance and actual results. Past performance­—whether
actual or back-tested­—is no indication or guarantee of future performance.
1
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Active Management and Emerging Markets Equities: Together They Work | 3
EXHIBIT 4
The evidence suggests that some managers in EM can
consistently take advantage of market inefficiencies. In
order to do so, managers need a strong professional culture,
sustainable investment process and comprehensive risk
management. The higher the quality of these factors and a
manager’s superior ability to employ this skill set, the greater
the chance the portfolio will outperform.
Investors must make a crucial qualitative judgment on
manager quality. The importance of thorough manager due
diligence by advisors and investors can’t be overstated in
the effort to find active managers who can be expected to
outperform the benchmark over time. In this context, it is
important to have a bias toward active managers who are
skilled at making diversified stock picks and proficient in
building portfolios that don’t just mirror a benchmark. Truly
active portfolios have a better chance of outperforming
benchmarks over time, which is quite an intuitive statement,
as in order to outperform, a portfolio must have differences
from its benchmark, whether in terms of position sizes or the
stocks themselves.
The concept of “active share” quantifies this intuition as the
percentage of a portfolio that is different than its benchmark.
The active share measure was developed by Martijn Cremers
and Antti Petajisto of the Yale School of Management, and
it determines the fraction of a portfolio that is invested
differently from its benchmark. The calculation sums the
absolute values of the difference between each stock holding
and each benchmark holding and divides by two to give an
active share value of between zero (portfolio is the same as
the benchmark) and 100 (portfolio is completely different
from the benchmark).
Portfolios showing an active share of below 60% are deemed
to be too similar to the benchmark index and receive the
ominous tag of “closet tracker,” charging active fees for little
more than passive management. To be considered active,
more than 60% of the portfolio’s weights must be different
from the benchmark (Exhibit 6). Importantly, research shows
that portfolios with the highest active share have enjoyed
market-beating returns, net of fees, over time. While having an
active share above 60% does not guarantee outperformance,
any outperformance appears to be highly unlikely without it.
80%
70%
60%
% of Quarters
The analysis can be further seen by identifying the top tercile of
best EM managers in terms of performance over 1-, 3-, 5- and
10-years. Exhibits 4 and 5 show the long-term sustainability
of their performance relative to their peers (Exhibit 4) and
relative to the MSCI Emerging Markets Index (Exhibit 5). The
data points for this analysis have been taken on a quarterly
basis.
Peer Outperformance by Top EM Managers
50%
40%
30%
20%
10%
0%
1 Year
3 Years
5 Years
10 Years
Top Tercile of EM Fund Managers, % of Quarters
of Sustained Top Two Quartiles Performance
Source: Mercer Manager Performance Analytics, February 2015
EXHIBIT 5
MSCI Emerging Markets Index Outperformance by Top EM Managers
76%
74%
72%
% of Quarters
framework pays off in inefficient markets.
70%
68%
66%
64%
62%
60%
1 Year
3 Years
5 Years
Top Tercile of EM Fund Managers, % of Total
Number of Quarters Ahead of Benchmark
Source: Mercer Manager Performance Analytics, February 2015
EXHIBIT 6
Active Share
Source: Copley Fund Research, February 3, 2015
10 Years
4 | Active Management and Emerging Markets Equities: Together They Work
Emerging Markets Are
Inefficient
EXHIBIT 7
25
1200
20
900
15
600
10
300
5
0
S&P 500
# Companies
0
BRIC
Average # Analysts
Source: UBS research, February 2015
EXHIBIT 8
0.30
0.25
EPS
0.20
0.15
Source: JP Morgan research, February 2015
Jan-15
Jan-14
Jan-13
Jan-12
Jan-11
Jan-10
Jan-09
Jan-08
Jan-07
Jan-06
Jan-04
Jan-05
0.10
MSCI Emerging Markets Index
It is important for one to recognize that a high degree of
variation exists across asset classes and EM equity is still
a relatively inefficient asset class where price information
is released slowly and reliable data is scarce. As such, this
provides opportunities for experienced and skilled managers
to add value through stock picking. For that reason, while
indexing may provide higher average returns in some of the
most efficient markets, this is not the case when it comes to
more specialized asset classes and strategies such as EM. For
example, the EM universe is very large and there are a high
proportion of stocks with little or no research coverage at all.
In fact, as Exhibit 7 illustrates, there are three times more
stocks listed in the BRIC countries than there is in the U.S.,
yet there are three times fewer analysts covering these stocks.
In addition, and perhaps a reflection of the low level of
coverage, the accuracy in forecasting EM earnings is lower
than in DMs (Exhibit 8). As a result, this opens opportunities
for fundamental analysis to exploit market inefficiencies.
Low EPS Estimates Accuracy (Standard Deviation of EPS
Estimates)
0.05
Analysts
Companies
Low Analyst Coverage
1500
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MDCI World (Developed) Index
RBC GAM Fundamental Series
Active Management and Emerging Markets Equities: Together They Work | 5
Stock Selection Is Crucial
When Investing
in Emerging Markets
EXHIBIT 9
On the other hand, by choosing active management, an
investor can select managers who can avoid these stocks.
In addition, investment prospects have rarely been more
differentiated between the various EM; several countries in
EM are implementing a number of political or social reforms
and will likely perform better in the long term once those
reforms are in place and prove to work (call out box, page 6).
Alternatively, passive strategies don’t differentiate; country
allocation is not an option and any investor in these vehicles
could end up missing significant opportunities.
150
100
50
Dec-09
Dec-10
SOEs
Dec-11
Non-SOEs
Dec-12
Dec-13
Dec-14
EM Benchmark
Source: UBS, February 2015
EXHIBIT 10
MSCI Emerging Markets Index Government Owned Company
Weightings
80%
70%
60%
50%
40%
30%
20%
10%
0%
China
Poland
Russia
Malaysia
Czech
Indonesia
Greece
Thailand
Brazil
GEMs
Colombia
Chile
Turkey
Taiwan
Egypt
India
Korea
South Africa
Mexico
Philippines
Peru
Hungary
For example, SOEs make up approximately 30% of the MSCI
Emerging Markets Index (Exhibit 10). Because of their weight
in the index and their high liquidity, passive strategies are
inevitably biased towards these large SOEs whose profits are
often used for social purposes at the detriment of minority
investors and as a result, have performed very poorly. If an
investor buys an ETF, that investor is effectively investing in
these companies.
200
SOEs
Many, if not most, passive indexes are market-cap weighted,
meaning that the investor is more exposed to the movement of
a few large companies than he or she may think. In addition to
this large-cap bias, these indexes tend to overweight certain
markets and thus have a large market bias. On the other hand,
active portfolios can be selective and this is crucial in EM. The
universe is huge and includes poorly run companies that have
weak corporate governance, particularly SOEs (Exhibit 9).
Large Representation of SOEs in the MSCI Emerging Markets Index
Source: UBS, February 2015
The GEMs category represents the average for all global emerging markets.
6 | Active Management and Emerging Markets Equities: Together They Work
A Benchmark Is a Poor
Reflection of the Vast
Emerging Markets
Opportunity Set
EXHIBIT 11
Number of Stocks in Emerging Markets Universe
9,636
822
EM Stocks Outside Benchmark
EM Stocks Included in Benchmark
674
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148
EM Mega/Large Caps
EM Mid/Small Caps
Source: JP Morgan research, February 2015
Unprecedented EM Reforms
China
Aggressive plans for privatization and reducing corruption
India
Widespread reforms to unlock bottlenecks
Indonesia
New government will focus on Energy and Infrastructure
Philippines
Targeting Infrastructure
Korea
Pursuing Chaebol reform
Taiwan
Finalizing services pact with China
Mexico
Reforms at full speed: Labor, Fiscal and Energy
South Africa
Incremental positive adjustments
Brazil
Economic management to improve
Chile
Better, more accessible education
The MSCI Emerging Markets Index is a poor reflection of the
opportunities offered by the EM universe (Exhibit 11). For
example, emerging markets small cap companies, frontier
market companies and developed market companies that
generate the majority of their revenue from emerging markets
are excluded from passive strategies that are narrowly limited
to including those only in the MSCI Emerging Markets Index.
On the contrary, active managers can choose to allocate to
these promising areas.
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Active Investments in
Emerging Markets Are
Compatible With the
Adoption of ESG Criteria
Active Management and Emerging Markets Equities: Together They Work | 7
EXHIBIT 12
Stronger ESG Scores Correlate to Higher Returns
20%
Further, there is a lack of comprehensive research coverage
in EM in general, and a dearth of ESG related analysis in
particular, which makes the bottom-up analysis of active
portfolio managers in this area increasingly important. Given
the higher levels of both risk and return in EM, investors who
make an effort to understand the impact of ESG on a company’s
earnings have a better chance of reducing risk and increasing
returns. Because information is scarcer in EM, managers see
ESG criteria as a way to make superior investment decisions.
ESG criteria can help identify long-term industry leaders
and potentially reduce investment risk by providing insight
into companies’ operations. As the strength of companies’
competitive positions and management of ESG risks and
opportunities become more important, the inclusion of these
factors into an investment process becomes crucial. A study
from Goldman Sachs (GS Sustain, Growing Pains, May 7, 2012)
shows that EM companies with stronger ESG have delivered
higher cash returns on average than their sector peers. In
addition, the same study shows compelling evidence that high
return companies tend to maintain those returns for longer
where accompanied by stronger ESG management quality.
Exhibit 12 depicts companies with first quartile ESG scores
tend to deliver higher cash return on capital invested (CROCI)
and sustain above sector average CROCI for one year (10%)
longer than average.
16%
14%
12%
10%
Q4
Q3
Q2
Q1
Management Quality (ESG) Quartile
Source: Goldman Sachs, May 2012
Stronger ESG Scores Lead to Sustainable Returns
Average number of years remaining in
same quartile of sector-relative CROCI
The integration of ESG criteria in passive management can
only be found in a small number of passive strategies that
benchmark against ESG indices. Conventional benchmarks
do not take ESG into account, and as such, most passive
strategies exclude favoring securities based on ESG criteria in
order to replicate an index’s performance.
Average CROCI
18%
Stronger management quality (ESG)
scores correlate with higher returns:
Companies with 1st quartile industry
positioning generate CROCI 3%
higher than their sector average
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Q4
Q3
Q2
Q1
ESG Quartile Relative to Sector Peers
Source: Goldman Sachs, May 2012
Not only does this evidence suggest that investing across ESG
lines in EM may create favorable returns, but also suggest that
investors following a strategy that adopts ESG analysis as part
of the investment decision process will help them to meet
investment goals.
Conclusion
We believe there is a strong case for active management in EM,
as demonstrated by the continuous outperformance of EM
active strategies over the MSCI Emerging Markets Index. As long
as EM is an ineffective market with little analytical coverage,
inaccurate earnings and return forecasts, investors can benefit
from active management’s abilities to glean valuable investment
recommendations. As the benchmark is not reflective of this asset
class’ universe, active managers are able to select well-researched
companies that are privately held and follow ESG criteria. Active
managers providing insightful market advice, a superior skill set
and new viewpoints, may help with successful investing in the EM
equities.
Authored by:
Guido Giammattei, Portfolio Manager, Emerging Markets Equity Team
RBC Global Asset Management (UK) Limited
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