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10th May 2017 | Dubai
By Mathieu Nègre, CFA, Head of Global Emerging Equities – Union Bancaire Privée
The asset management world is increasingly polarized – passive and index funds as well as ETFs are even well established in institutional Emerging markets equities portfolios now. Yet, active managers need to increasingly justify the “active” in their claim to avoid being labelled as mere “closet indexers”. However, market participants always face the same challenges: how to outperform the correspondent index as greatly as possible with strict risk restrictions at hand. Additionally, results often need to be short term in order to meet the various accounting standards in various jurisdictions. That is simply often not possible if benchmark titles are kept in the portfolio. However, institutional investors often ask for exactly those stocks. This proves to be a seeming conundrum for investment professionals – in particular, as active managers need to prove their costs over and above the above named cheaper investments.
Many Emerging markets fund managers have tried various approaches to their investments over the last few years in order to restrict risk and increase returns for clients: from equal country weighting to risk parity, over to maximum diversification or minimum variance models. Evidently, most of those strategies led to an improved risk-return profile versus the standard index over the period tested from 1988 – 2015.
Yet the Foreign exchange volatility remains high and unstable for a lot of emerging market countries so, a closer look to country allocation seems inevitable. In fact, the average annual standard deviation and the difference between the best and worst annual performers is consistently larger for Emerging market countries when compared to sectors. Thus countries are as much a prime source for risk as they are for return.
Surprisingly, the focus on country risk evaluation, however, has simply not been fashionable even though it prove more efficient. Rather, risk-reduction strategies often start at the stock level with low volatility funds or a quality bias. The focus and investor pressure on short term investment results add to portfolio managers shying away from country allocation focus in Emerging markets equities portfolios. Interestingly, the under-appreciation of country risk is one particular aspect though that investors do not consider strongly enough. This might have come more to their attention in 2016 and changed as we are facing drastic political changes in established countries such as the USA and also Great Britain at our “doorstep” – as they are simply closer to our overall Western perception and awareness levels. In fact, Goldman Sachs pointed out in its research (EM Cross-Asset Strategy, Gauging Country Risk” in August 2016) that regardless of the asset class country risk is central to Emerging markets investing. It is also fair to point out that geopolitical and socio-cultural factors are often not taken into consideration seriously enough in assessments.
But where better to start for an EM-portfolio though in terms of country allocation than to look at the relevant index? A stock index is made up of the weighted average equity rather than the mathematical average which significantly influences the benchmark composition. Most of the broadly used market indexes today are also cap-weighted indexes. However, in a cap-weighted index, large price moves of the largest components can have a dramatic effect on the value of the index. This is why non-cap weighted benchmarks have gained in popularity over the recent years, even if they deviate from the traditional methodology.
In the case of “younger” benchmarks with former exotic investments this proves to be an even more delicate topic. The MSCI Emerging Markets Equity Index is one such example. It was launched in 1988. In its early days it comprised of ten countries representing less than one percent of the world´s capitalization. As the globalisation increased and, with it, the amount of available and investable money, so did the emerging countries economic growth increase. Today, Emerging markets are world encompassing: a total of 23 countries are regarded as Emerging Markets, ranging from South America, Eastern Europe and the Middle East over to Asia. They are home to more than 800 large and midcap companies that are represented in the MSCI Emerging Markets Equity Index. Chinese corporation currently make up 26,82 percent1 of the overall participants and country proves to be an interesting example.
It is only a matter of time for MSCI to acknowledge that Chinese mainland shares need to be included in their benchmark as the country realized the Shanghai Stock Connect programme in November 2014 and announced the Shenzhen Stock Connect Programme in 2016. There are still some regulatory hurdles ahead but MSCI communicated already in June 2015 that it was a matter of “when, not if”. Understandably, Chinese authorities are keen for this move – however, when this inclusion will take place, which is likely to be gradual in order to avoid liquidity problems, the weight of China in the MSCI Emerging Markets Index will increase from 26 to 40 percent. This pro-forma calculation has been published by MSCI itself and should also impact other Asian-focused benchmarks. One non-discussed possibility would be to exclude China from the Emerging Markets index and give the country its own proper index. However, as to current public knowledge there are no moves in to that direction. Yet, this change would massively impact institutional portfolios and their performance as well as risk parameters all over the globe. In fact, countries who have reached a certain high size of share in an index sometimes tend to underperform, such was the case with Malaysia that reached its index size peak with 30 percent in 1988 and then subsequently underperformed by minus 49 percent until 1992 (based on relative performance). The same development was seen with Mexico in 1990 who also held 30 percent of the index size and, who then underperformed (relative) by minus 68 percent until 1995.
Yet, there are no current regulatory efforts known to actually combat the possible concentration levels in indexes. And, as inflows in passive products such as ETFs and index trackers have increased enormously there might actually be no incentive to change this in the near future either. There are some small local efforts being conducted in other sectors where the subject is addressed – for example, the Israel stock exchange communicated in November 2015 that it would limit the weight of new entrants to its major indexes to four percent in a bid to attract new companies. In Israel´s case a major over-representation of the pharmaceutical sector was about to happen due to a dual listing of one of its participants.
So, where does it leave Emerging markets equities investors in search of a solid diversification with no single country bias? In fact, a good risk diversification would be to focus on a sensible country allocation strategy. Moreover, country weighting risk can be managed with various strategies, according to investor preference, and can thus be integrated in the overall Emerging Market portfolio through different approaches. Of course, this is only one step in the establishment of an active investment process. Stock selection, portfolio construction and risk management are equally critical. But overall, allocation strategy also benefits the overall performance by helping reduce the systemic risk in the overall portfolio.
 Source: MSCI
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