Not all active managers are as active as you might expect –‘closet indexers’ are becoming ever more prevalent. This can surprise investors in those managed funds who expect an active manager to be active but actually receive a close-to- benchmark return. Conversely, depending on the benchmark followed by passive investment strategies, investors can be unwittingly invested in some surprisingly risky indices. Due to their composition, some of these benchmarks are actually very active bets on certain market risks and thus can entail higher risks than investors expect for a ‘passive’ strategy.

In our view, it is important for investors to truly understand their investment managers and the risks that they are taking on. These issues have implications for expected returns.

In a world where the lines between passive and active are becoming ever more blurred, the identification of ‘true-to- label’ managers is crucial.

Active strategies are often more passive than people realise

Active investing seems to have failed investors’ expectations over a long period of time. On average, active funds have underperformed the market index by a statistically significant margin. This has led to an explosive growth in passive investing over the past decade, in large part because it is difficult for investors to justify paying active fund fees if active managers don’t generate alpha.

However, all is not necessarily as it seems.

Dr. Martijn Cremers and Dr. Antti Petajisto of the Yale School of Management analysed this topic in 2007 and proposed the concept of ‘active share’, which is defined as the percentage of a fund’s portfolio that differs from its benchmark index. In his 2010 study of the US fund management industry from 1980- 2009, Petajisto observed that actively managed mutual funds in the US saw their active share ratio consistently decline from 60% to less than 20%. He defines anything below 60% as ‘closet indexing’.

Petajisto’s conclusion is that on average, fund performance is correlated with the degree of management as measured by active share. The study shows that declining active share in so-called actively managed funds is what led to theunderperformance. This is because managers began hugging their benchmarks for a variety of reasons (job security, pressure to produce high IR, rigid risk control environment, swelling AUM, etc). The most significant catalyst may have been the GFC–when market volatility began to increase and stocks suffered severe losses, the pressure on managers to mitigate relative underperformance and increase risk controls was immense. This caused managers to align their portfolios more closely to a benchmark index in an attempt to reduce the risk of major underperformance and stem outflows from their funds.

However, the study shows that the most active stock pickers outperformed their benchmark indices even after fees and transaction costs. Concentrated stock-picking can produce consistent excess returns, whereas managers that purport to be ‘active’, while actually hugging a benchmark, can underperform. In the study, non-index funds with the lowest active share score underperformed their benchmark by over 1% annually net of fees.

Our investment management teams believe that it is important to take active positions based on the fundamentals of issuers, stocks and fixed income securities. Valuation is crucial to the delivery of long-term returns, while closet index tracking can be detrimental to real returns and the preservation of capital. We view benchmark indices as a useful way to measure long-term performance compared with the broader market and not something to be rigidly followed as part of the herd. As global investor Sir John Templeton said, “if you buy the same securities everyone else is buying, you will have the same results as everyone else. By definition, you can’t outperform the market if you buy the market.” If you claim to be an active manager, then you should be actively managing portfolios with high conviction calls and not just chasing the index.

Passive strategies more active than you might think

Apart from lower fees, passive strategies seem to offer the perception of lower risk than active management since index funds shouldn’t underperform the benchmark. However, passive strategies replicate the composition of a particular index, which in itself implies certain market bets depending on which regions and/or companies it comprises. Passive investment strategies can actually be riskier than investors expect since certain benchmarks actually entail very active bets on certain market risks.

As an example, if you look at the MSCI Emerging Markets Index over the past two decades, its composition has changed dramatically (see chart 1). Asia’s portion now accounts for almost two-thirds of the Index, compared with less than 50% when Asian Financial Crisis hit. MSCI is due to review the inclusion of China’s onshore equity market in its benchmark Emerging Market Index next year with a proposed initial 5% weighting. When this happens, it will cause a major shift in the index composition so that passive investing in that index will entail a direct exposure to Renminbi-denominated securities.

Thus, buying an Emerging Markets index can actually be a very active form of investing. ‘Passive’ Emerging Market investing with a market capitalisation-weighted index in effect means following a momentum-based strategy, where you increase the weight of the best performing regions and companies every year and sell the losers. Market capitalisations and stock returns drive the portfolio weights, dictating how much you invest in each region and each underlying company.

There is nothing wrong with momentum investing, but investors must understand that it works in certain cycles and fails in other cycles, so it may not be as ‘low risk’ as they expect. This is particularly true for passive strategies investing in China and shows how passive investing may actually be a very active form of investing when the choice of a market benchmark is not straightforward.

Due to market controls and government regulations, there are currently several exchanges where Chinese companies list and four or five indices that an investor can access to invest into China. But if you look at the components of these indices, they are vastly different in terms of what they cover.

Depending on which index you choose, you may be investing in the largest State Owned Enterprises in China where most of the ownership is still Beijing-controlled, or you may be more weighted towards private enterprises. Looking at the returns over the past two years, the differences might make you think that they are related to different continents altogether (see table below).

In effect, a passive investment into China is actually a very active bet on a particular sector of the Chinese economy. Factors in Emerging Markets are far too complex and too fluid to have a truly passive investing strategy so benchmark selection is crucial.

In addition, as Emerging Markets recovered from the GFC, the correction started to reflect regional dynamics and themes. These regional fundamentals have started to drive stock prices much more than macro events. For example, earnings from Asia have been rising much faster than the rest of the Emerging Markets (see chart 2). Looking at the differences in underlying fundamentals, you can see that labeling everything under the Emerging Markets banner may be an oversimplification of risks and returns in a ‘passive investing’ strategy.

By Yu Ming Wang Deputy President, Global Head of Investment, CIO International, Nikko Asset Management

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Disclaimer: This material is issued by Nikko AM Limited ABN 99 003 376 252, AFSL 237563 (Nikko AM Australia). The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs, figures, etc., contained in this material include either past or backdated data, and make no promise of future investment returns, etc. Past performance is not an indicator of future performance. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.

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Principal Global Perspectives

The global emerging markets landscape is changing rapidly, with the outstanding returns investors have seen in the past becoming increasingly difficult to secure.

According to Principal Global Investors, despite the volatility, emerging markets are a strategically important part of long-term investment portfolio and determining the right market exposure is more critical than ever.

The October issue of Principal Global Perspectives focusses on emerging markets, providing a compilation of articles from four of its boutique asset managers on what they see as the challenges and opportunities in this progressing asset class.

Key points:

• Waiting for growth no longer, emerging markets take action, by Milhail Dobrinov, Portfolio Manager, Principal Global Equities: “So how are emerging countries to prosper, and emerging stocks to regain their edge and outperformance in this new environment? The answer lies in applying a large dose of self-help; not just waiting for growth to happen along, but taking steps to create it. That means boosting productivity growth, reducing operating and capital costs, improving profitability, and returning more capital to shareholders. At the country level, this means structural reforms; at the firm level it requires prioritizing return on capital, rather than growth at any cost. These changes are necessary, but neither of them will be easy or popular, and some attempts will stumble.”

• Emerging markets forge ahead … on differing paths, by Ivailo Vesselinov, Economist, Finisterre Capital: “Emerging economies with large financing needs are likely to remain under the microscope as major central banks rein in global financial liquidity.”
• What to watch in emerging markets: aggregate ROI, by John Birkhold, Partner, Origin Asset Management: “What matters is not how fast a company is growing, per se, but the level of ROI that firms in aggregate have been able to achieve.”
• Emerging markets debt: as asset class evolves, by Nick Varcoe, Portfolio Manager, Principal Global Income: “Institutional buyers are likely to remain active in the emerging market corporate space, particularly as long as this attractive yield pickup over developed markets continues to exist.”

To read the full report, click here.

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Craig Mowll

The loss of momentum in Europe and the absence of any new potential driver to push European equity markets to new highs will see retail investors increasingly turn to Asia over the next 12 months according to Louis Vincent Gave, COO and Chief Risk officer of GaveKal Capital, on the eve of his Australian visit.

With little to keep retail investors and the marginal investment dollar in Europe, Asia looks well positioned to capitalise on Europe’s loss, particularly with the MSCI Asia index now outperforming the MSCI World for the first time since the first quarter of 2010. Adding to this woe Eurozone equities are now underperforming cash, gold, local bonds, international bonds and international equities.

Mr Gave commented, “Unfortunately for Europe, the marginal investment dollar is more often than not highly momentum-driven and chases performance. That’s because it is usually provided by the retail investor, and retail investors have a long track record of being momentum jockeys.”

This also mirrors the attitudes of investors in Australia according to GaveKal’s Australian partner, Certitude Global Investments. CEO Craig Mowll commented, “Our monthly investment Index, the CGIII, surveys the attitudes of Australian investors and our last report echoes this sentiment. In fact Asia was one of the few regions to stand its ground when investors were asked which international markets they were most keen to invest in over the next 12 months. Most other major markets saw a decline in investor appetite.”

But both GaveKal and Certitude have cautioned investors that not all boats will rise with the tide and country divergence is ever more important. There are widespread differences between the emerging markets within Asia, they agreed.

Mr Gave expanded, “Between 2003 and 2010 there was a high correlation between Asian equity markets driven by the emergence of China as an economic powerhouse, the quintupling of energy prices and the GFC and recovery, but since then the correlation has loosened tremendously. China, Hong Kong and South Korea have been underperformers as growth in China has decelerated. Meanwhile political developments in India, the Philippines and Indonesia have been drivers of the markets.”

The recent CGIII lends further support to this. Mr Mowll added, “We saw in the August CGIII that within Asia the attitudes to each country vary enormously. We saw appetite for Asia increased on the whole, however on an individual basis, interest in China was down slightly while India and Japan were on the increase. The balance of payment surplus and good inflation levels in the Philippines will also make this a stand out for investors.

“Asia is not a homogenous group and investors will increasingly look for managers that act on this and factor this into their portfolio construction.”

One of the key themes of Mr Gave’s Australian visit will be stock selection and he is expected to suggest that the days of casting a wide net are also over, with individual stock selection more important in light of the tremendous divergence within markets. Mr Gave explained, “There is a focus now to concentrate the portfolio on strong conviction ideas to add more value. If we look at Chinese internet stocks versus SOEs or Japanese banks versus exporters these are clear cases in point.

Mr Mowll concluded by saying that investors are increasingly seeking the expertise to give them the confidence to invest in Asia.

He concluded, “Australian investors are informed enough to know that Asia is not one homogenous emerging market but they may not have the time to understand the impact of demographic profiles, political and economic developments on the performance of individual markets. This is why they turn to an investment manager that is nimble enough change the portfolio quickly as the region evolves.”

Louis Vincent Gave will be visiting Australia as a guest of Certitude next week.

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Romina Graiver

Recently in Australia to promote William Blair’s Unit Trusts, launched earlier this year, William Blair’s International and Global Equity Specialist, Romina Graiver, said the Chicago-based asset manager uncovers many quality opportunities in emerging markets.

“Investors know about the growth story in emerging markets however we believe in many cases they underestimate the quality aspect of it,” she said. “Sustained high level of economic growth has enabled many emerging markets companies to generate consistently higher returns on assets and capital. We also acknowledge that some areas and macro events have provided a tailwind effect for companies to do better as they benefit from an economy that is growing, rather than contracting, which is where we are seeing that there is a bit of de-coupling.”

Finding high quality growth companies in emerging markets is Chicago-based global asset manager William Blair’s driving theme with approximately a third of their 2500 global quality growth investment universe made up of emerging markets companies.

Ms Graiver said some emerging markets companies within William Blair’s Emerging Leaders strategy also belong to the Global Leaders strategy, which demonstrates that these companies can be among the highest quality on a global scope.  “We use the same process, research and analysis for companies in both portfolios but it is tougher for an emerging market company to get into the Global Leaders strategy because of the broader opportunity set,” Ms Gravier said.

“William Blair looks at the top down views, but at the end of the day, we use bottom up fundamental analysis to find quality growth companies with strong governance. We are not going to play a theme if we are not finding the best quality growth companies in that theme,” Ms Graiver said. “In emerging markets we like countries where we see tailwinds for companies to do even better, for example countries where we see opportunities for reform, rather than countries where the macro trends are a headwind for companies.”

“We like India and Indonesia for instance,” Ms Graiver said.  “In India we increased our exposure well before the elections. India is a market where we often find very high quality companies with very strong management – like IT services and pharmaceuticals. Early this year we increased our exposure to more cyclical names, which are expected to benefit from an improvement in the domestic economy. We also like auto-related companies in India, some of which are benefiting from car demand recovery and improved sentiment.”

Ms Graiver said William Blair saw a real growth opportunity for India with the likelihood of the Modi pro-growth government coming to power, which would provide a better framework for these quality companies.

“We looked at Modi’s previous work as a provincial Governor and how this boosted GDP growth and in his work fighting corruption and bureaucracy along with feedback from companies who had different activities in different regions.  The standard of living in Modi’s Gunjarat province was much higher than other regions of India.”

William Blair has increased exposure slightly in Indonesia, Ms Graiver said, where there are some high quality companies and again there is likelihood for reform with a new government. William Blair has also increased to an overweight position in Mexico due to the clear intention for structural change and also the benefits of proximity to the United States as a trading partner.

Ms Graiver said in contrast to the above, Brazil, which is struggling with slow growth, high inflation and a current account deficit, does not look compelling from a top down perspective. There are, however, some very attractive  companies with strong operating performance and growth prospects. “Despite the weak macro environment, some companies are benefiting from secular growth drivers, such as evolving consumption patterns driven by social demographic changes; others are supported by government policies  like in  the education space” Ms Graiver said.

In China, William Blair is underweight, however, less than before. Ms Graiver said William Blair sees some optimism regarding recent data reports, helped by mini or targeted stimulus measures however, they see a long term deceleration of economic activity. “China is going through a big deleveraging process which will reduce GDP growth,” she said.  “The government seems committed to reform and is moving forward in many areas (financial reform, SOEs, etc) but at the same time they have to manage the gradual transition from high-leveraged and investment driven economy to a more consumer driven economy. There may be some pain along the way however there are areas in China that are seeing favourable growth trends and the market is attractive from a valuation perspective compared to other markets and compared to its own history.”

In the end it is William Blair’s ability to select quality stories in their universe of emerging markets which benefit from the tailwind of prospects and growth at a macro level which is an additional driver of performance.

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By grouping countries according to key economic characteristics, investors could guard against volatility.

Emerging markets investors should move away from the flawed BRICs concept and frame the investment landscape in terms of country blocs that perform similarly as the macro environment evolves, according to Investec Asset Management Global Strategist, Dr Michael Power.

Dr Power presented an analogy where emerging markets were at the mercy of two tides – liquidity, governed by the ‘American moon’, and commodities, ruled by the ‘Chinese moon’.

By grouping countries according to key economic characteristics, investors could better understand how markets react to the movement of the two tides, and position themselves more intelligently against future volatility, he said.

“There are four main blocs within the emerging markets asset class, and they are not a matter of geography,” Dr Power said. “It’s more useful to firstly distinguish between whether a country tends to run a current account deficit or surplus, and secondly whether it is primarily a commodity or manufactured goods exporter.”

The new building blocs

Dr Power explained that by this theory, oil exporters could be grouped in the north-east bloc; sub-Saharan Africa, South America and Indonesia in the north-west bloc; Mexico, Eastern Europe, Turkey and the Indian sub-continent in the south-west bloc; and China-centred East Asia in the south-east bloc.

“The developed world can also be handily described by this matrix”, said Dr Power. “Oil-exporting Norway is in the north-east; Australia, Canada and New Zealand are in the north-west; the US and UK are in the south-west; and Japan, the Eurozone, Switzerland and Scandinavia are in the south-east.”

The financial health of the western bloc countries is closely tied to global liquidity, while the northern bloc’s prosperity is linked to the commodity cycle. “For instance, 2011 saw the high tide for commodities coincide with strong liquidity flows from quantitative easing. This was ideal for the north-west bloc, with both the Brazilian real and Australian dollar reaching their peak values,” he said.

Areas of focus for the future

Dr Power believes the south-eastern bloc, led by China-centred east Asia, presents the strongest opportunity for emerging market investors.

“The characteristics of this bloc tend to reduce the risk profile in all asset classes, in that they tend to create a less volatile economic environment,” he said.

“As a result, smart money – sovereign wealth funds in particular – are seeking a more focused exposure to this region.”

However, Dr Power explained the approach wasn’t foolproof, with regional events playing a role beyond the twin tides of liquidity and commodities.

“As evidenced by the Ukraine crisis, specific events can and do impact individual countries, more often negatively,” he said. “But for investors the bloc approach will make much more sense going forward than the BRIC approach, which is essentially an exercise in sizeism.”

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Emerging markets look good for the rest of 2014: Van Eck Global

Emerging markets economies are poised to offer higher economic growth for the remainder of 2014 than recent previous corresponding periods, according to Van Eck Global, the US parent company of its exchange traded fund business, Market Vectors ETFs. Van Eck Global currently manages over US$35 billion in assets.

David Semple, Portfolio Manager and Head of Van Eck Global’s Emerging Markets Equity Investment Team said, “The tide is turning for emerging markets, which outperformed the broad US market in the second quarter of 2014—an event we’ve not seen for some time. The asset class attracted particularly strong inflows in April and May this year, the highest inflows since March 2013.

“In the second half of 2014 we believe emerging markets will continue to perform solidly, providing better earning outcomes than we’ve seen in the past three years.”

According to Mr Semple, investors are beginning to warm up to emerging markets again as better earnings typically indicate a recovery. He believes the main risks for emerging markets in the second half of 2014 are geopolitical and interest rate sensitivity.

“Ongoing tensions in Ukraine have impacted the Russian economy and the escalation of sanctions will have a broader impact on a fragile European economy. The earnings impact from the sanctions as they exist today is fairly mild, but we think the cost of equity will rise as investors shy away from the possibility of further and more serious geopolitical tension, combined with the possible implementation of full sanctions on listed companies.

“China continues to provide a mixed picture. There is a wide range of opinions, and a great deal of scepticism about the China story,” Mr Semple said. “There is a continuing tug of war between significant positive and negative economic variables. We believe the ongoing modest and targeted stimulus is expected to continue and keep growth above the 7% to 7.5% level. Despite all that, it’s important not to forget the positives, such as the fact that China has the largest e-commerce economy in the world,” he said.

Despite geopolitical risk, Mr Semple believes most emerging markets countries have absorbed a significant amount of bad news. According to Semple, there are good opportunities in Taiwan, India and Latin America.

“The decisive win for the Bharatiya Janata Party (BJP) in India appeared to be beneficial for the stock market, although there are major hopes for better governance and acceleration of capital expenditure in the near-term. In Brazil, the outcome of the election in early October will be important. We expect a change of government will have a positive impact and will help reinvigorate the stagnant economy,” he said.

“Indonesia has some very significant long-run advantages in terms of demographics and resources, but has significant work to do to increase the return on those assets. This will mean increasing the ease of doing business, whether by investing in infrastructure, streamlining bureaucracy, reducing subsidies, and providing a level playing field for investments.

“We believe emerging market economies will continue to offer higher economic growth in the medium term, particularly as investors increasingly diversify away from their domestic economies and identify better value in stronger performing emerging market economies this year and into 2015,” Mr Semple said.

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Strong positive flows were seen across the US, Europe and APAC, with Australia based ETFs receiving $368m in flows – improving on last month’s record inflow of $354m.

The increasing escalation in the Ukraine, ongoing tensions in the Middle East, Argentina’s latest default and concerns about the Federal Reserve’s intentions did not deter global ETF investors from investing heavily in equities in July. Of the US$35.5bn invested in ETFs across globe during July, 82% of these flows were to equity-based ETFs in July.

Looking a little deeper into recent trends, we can see that Emerging Market equities have seen a rapid return to favour with ETF investors adding heavily in Emerging Market equities for the 3^rd month in a row.  This follows a period of significant outflows from the asset class due to concerns around the evolving political landscape and Chinese reforms concerns.

Unlike their global peers, Australian ETF investors remained cautious on emerging market equities with cash outflows over July the largest over the last 12 months.

While global ETF investors clearly favoured the attractiveness of higher growth emerging economies in recent periods, we expect continued convergence of economic growth from advanced and Emerging Economies due to an improvement in the advanced world and a stabilisation of Emerging Economies. Our expectations are that the global economy will expand 3.5% in 2014 and 3.8% in 2015.

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Professor Amin Rajan

Outstanding returns from emerging markets may be a thing of the past, as investors become more discerning and economies develop at very different speeds.

This was one of the key findings from “Not all Emerging Markets are Created Equal”, the 2014 annual CREATE-Research report (the Report), commissioned by Principal Global Investors and its parent company, Principal Financial Group® and released today. The Report distills the views from 704 pension plans, sovereign wealth funds, pension consultants, and asset managers from around the world and reveals in-depth insights from structured interviews with 110 organisations.

Given recent volatility and sell-offs in emerging markets, this year’s Report addresses whether emerging and developed markets will continue to converge, and where global investors are likely to see value in the coming years. These questions and others are framed against the backdrop of the likely effect on global markets of four unknowns: the tapering of quantitative easing, slow deleveraging in the Eurozone, the “three-arrow” initiative in Japan and the credit explosion in China.

The Report reveals that despite recent poor performance, investors have not lost faith in emerging markets. However, they are becoming more discerning as as emerging markets are increasingly considered a tactical investment opportunity. In addition, emerging markets are no longer seen as a homogenous group and only those countries embracing a reform agenda are likely to continue to converge with the West, both structurally and financially.

Professor Amin Rajan, CEO of CREATE-Research and the author of the Report, said that by way of example, 35% of respondents said that China would deliver real growth over the next three years, whereas only 15% thought that Brazil would. In the same way, nearly half of respondents believe China will push forward with economic reform, but only 6% think that Russia will.

“Marked volatility and concern about the political will to aggressively pursue a reform agenda has certainly made investors more wary about their previous ‘buy-and-hold’ strategy,” Professor Rajan said. “And as a result, more investors view emerging markets as an tactical play.”

Professor Rajan went on to say that neither emerging nor developed markets would return to full health until some root causes of global weakness are addressed.

“Reducing debt, strengthening public finances, promoting growth and boosting competitiveness are challenges which Governments across the globe must all find ways of meeting,” he said.

Commenting on the findings of this year’s survey in the Australian context, Grant Forster, CEO of Principal Global Investors (Australia) noted that some of the previous strong returns from emerging markets were clearly more about quantitative easing than they were the inherent strength of the economies in question.

“Now that tapering has begun, the cracks are starting to appear in some economies,” he said.

“Countries which continue to backslide on reforms and are struggling under the weight of massive trade and budget deficits are unlikely to perform looking forward.”

Mr Forster said that the revelations from the Report raised important questions for Australian investors, as they come to terms with the fact that the economies within emerging market groups, often described by catchy acronyms, like BRICS, will no longer move in lockstep.

“These acronyms were more marketing driven than investment driven and highlight the inherent dangers of oversimplifying opportunities in complex and less developed economies and markets. These markets contain diverse economies and societies – they do not move in lockstep over the medium-term,” he explained.

Mr Forster went on to say that the Report also raised the interesting questions about the future for frontier markets. Investors have typically been cautious about these markets due to their higher levels of risk.

“It’s true that despite the positive outlook for population and growth in some frontier markets, the political and governance risks remain real, and for the time being these markets are still very illiquid,” Mr Forster explained. “However, it is likely that we will start to see the kinds of changes we saw in emerging markets in frontier markets in the future.”

In conclusion, Mr Forster said that while there may be marked differences in the pace, developing markets will, by their nature, continue to progress.

“A strategic allocation to emerging markets will definitely remain important to investors with a long-term perspective, and even at the moment, emerging market equities look attractive on a relative valuation. Given the diversity and very different stages of development of emerging economies and markets it is also prudent to consider opportunistically shorting from both a hedging or alpha perspective.

“Drawing on the skills of specialist managers to help identify specific opportunities will be the trick,” he said.

Key findings of the report include:

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Mark Burgess

Looking forward to 2014, Threadneedle Investments believes the year will be characterised by the move towards financial markets standing on their own feet again, as the global policy support that has been providing abundant liquidity to markets starts to be withdrawn.

This will mark an important change in the drivers of investment returns:

Mark Burgess, Chief Investment Officer at Threadneedle, commented: “Following many years of liquidity provision from the world’s central banks which supported the performance of ‘risk assets’, 2014 will be about selecting the right investments as the global economic recovery will be put to the test. Financial markets will have to re-engage with reality against a backdrop of significant macro and policy challenges and investors need to be alive to the consequences of this changing environment and subsequent volatility. What happens if QE is withdrawn too quickly? What risks lie ahead if companies don’t deliver earnings growth?”

Equities

“While we remain bullish on equities overall, regional and sector performance will vary significantly. Investors are increasingly shifting their focus away from market liquidity to company fundamentals following the Fed’s announcement in September that it is preparing to start turning off the QE tap. Companies will have to step up their game and earnings will have to pick up significantly if equities are to sustain or even come close to the rally we have seen in developed markets during 2013.

“US company earnings have been at the forefront, having recovered and surpassed their previous peak. We don’t think this year’s returns of close to 30% will be repeated in 2014, but US equities remain attractive. The banking sector is well capitalised and has started lending again, providing a boost to the economy. While the debt ceiling remains a risk, a combination of low energy and labour costs should support company margins into 2014. We think the best performers will be companies in the technology and consumer discretionary sectors.

“In contrast, only half of European companies have beaten earnings expectations so far this year. The region remains beset by relatively poor growth dynamics compared with the rest of the developed world. This year’s stock market recovery could easily herald a false dawn. The banking sector still has a long way to travel to address its capital shortage, although the fundamentals are much improved. While for the first time in three years we believe Europe is likely to return to positive GDP growth in 2014, earnings growth is likely to be steady rather than dramatic. Stock pickers, however, could be handsomely rewarded when concentrating on companies with strong business models, robust finances, experienced managements and ideally dominant market positions.

“While the UK economy is still smaller than it was pre-crisis, we have seen some very encouraging data in 2013 and there could be a surprise uptick in GDP growth of around 2% next year. Unemployment has been falling and there is a likelihood that the BoE’s 7% threshold will be reached in late 2014. The problem is that the positive data has not necessarily translated into domestic profits thus far and companies are likely to end the year flat. On the upside, we have seen a pickup in IPO activity and expect the improved economic backdrop to further drive corporate confidence and activity in 2014. We think the best returns are going to come from industrials and the consumer discretionary sector, with consumption (and housing) having driven the economic recovery to date. However, relatively little economic rebalancing has taken place to date, something that has been exacerbated by the success of the ‘Help to Buy’ scheme and raises questions over the sustainability of the recovery.

“Japan has embarked on a clear and credible path, and ‘Abenomics’ has been transformative. Low interest rates support credit growth and 80% of companies are set to raise base salaries.^[1] More challenges lie ahead but we expect further gains in equities and are overweight in financials and beneficiaries of policy action.”

Fixed income

“2014 will be a year of transition for bonds. The expectation of QE tapering has already led to the end of the bond market rally, although we see no evidence for a rotation out of the asset class as demand from pension funds and banks remains. In sovereign markets, we expect yields to move gradually upwards, with the 10-year US Treasury yield at around 3.5% by the end of 2014. While we may not witness a return to the historic norms just yet, the gap between equity and bond yields should slowly start to normalise, so the “risk-on” stance that has worked well for investors during the last few years becomes less glaring in 2014. In fact, corporate credit as an asset built for a slow growth environment should perform well next year, having already delivered positive returns in 2013. High yield in particular has had a good year and we expect this to continue. Company balance sheets are robust and we see defaults as very unlikely.”

Emerging markets

“Emerging markets are a mixed bag and a wildcard in 2014. The announcement of QE tapering has caused significant headwinds in fixed income assets and concerns over currency volatility and current account deficits remain. Equity valuations are attractive, but history shows that rising US Treasury yields and a stronger US dollar can have a negative impact on EM returns. In addition, GDP growth in countries such as Brazil is unlikely to look spectacular compared to the developed world. On the upside, Mexico points to a year of solid growth linked to the US economic recovery and the country’s lower manufacturing cost base compared to China. While the latter has impressed us with the third plenum, stock picking is going to be of particular importance over the next few years. Equally, domestic markets in Latin America and those emerging market companies that are geared to an economic recovery in the developed world should not be dismissed.”

Commercial property

‘We expect the UK commercial property market to deliver good returns in 2014, as the economic recovery continues to positively impact upon occupational demand. The main beneficiaries should be the South East, as well as logistics and warehousing markets across the country. Top provincial office markets are also showing some signs of recovery. We believe investors will continue to be attracted to commercial property next year and competition for stock will place upward pressure on capital values.”

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^[1] Japanese Ministry of Labour and Welfare survey

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The last decade may offer little guide to the future given that investors in emerging markets benefited from a rare, synchronised upswing in 2003-8 where all markets were lifted by a rising tide – a free lunch was on offer. Where an indiscriminate or passive approach worked in the past, it is unlikely to fare so well in the future.

Emerging markets will still grow faster than developed markets and should remain a source of attractive returns. However, there is likely to be far greater differentiation between markets, sectors and stocks. Active management of investments will be vital as country and stock fundamentals reassert.

Looking forward, country, sector and stock selection are likely to be paramount as divergences reassert themselves. Previously, investors made strong returns by investing indiscriminately in global emerging markets. This ‘free lunch’ is now over.

The free lunch is over

The last decade was remarkable. So remarkable, it is unlikely to be repeated. Synchronised growth in emerging economies and stock markets from 2003-2008 was unprecedented in its strength and breadth. In fact, by 2007, only three countries in the world suffered negative economic growth as a rising tide lifted all boats. Global stock markets were driven much more by macroeconomic factors than previously. There were two key drivers behind this rare ‘Goldilocks’ phase:

• The global economy, especially emerging markets, benefited from a flood of debt-fuelled liquidity, or ‘easy money’.
• Double-digit Chinese growth provided a strong tailwind for emerging markets, supporting commodity demand, and painting a compelling narrative for investors.

Without a continued supply of ‘easy money’, growth in emerging markets should ease back to historical averages and we can expect more volatility in business cycles. As growth rates diverge, investors must view emerging markets as individual stories, not one heterogeneous bloc. Selectivity within emerging markets will be crucial, requiring a more active approach.

The next decade is unlikely to be a continuation of the last

Investors have a habit of extrapolating the recent past into the future. But, history shows that economies and markets do not move in straight lines. The next decade is highly unlikely to offer a continuation of what worked in the last. The implications of China’s economic rebalancing will create winners and losers across emerging markets. In addition, unanticipated political and technological developments are bound to have a bearing on global economic trends. At the start of the 1990s, forecasters would have taken little account of the impact of the internet or China.

Throughout history, the baton of emerging-market leadership has been passed among a diverse set of nations. Some grew quickly and offered promise before falling out of the MSCI Emerging Markets Index due to political regimes that applied controls to capital flows (e.g. Argentina and Venezuela). Economic convergence is not a given; it is hard earned. It is vital to differentiate between markets that will continue to emerge in a positive manner from those at risk of ‘submerging’ from previous highs, for example through eroded competitive positions or excessive populist policies.

Indices: A better reflection of past success than future potential

As chart 2 shows, the composition of emerging markets has changed considerably over the last decade. The exceptional growth of certain large markets has resulted in a much greater degree of concentration in the MSCI EM Index than was present at the start of the decade. In 2000, investing in the index meant allocating across a broad spread of emerging countries with Brazil, Taiwan and Mexico accounting for just over 10 per cent each. Investors who bought the index in 2000 benefited from the double whammy of increasing exposure to strongly performing winners like China and Brazil.

Now, investing in the index means allocating large portions to China (18.7%) and Brazil (10.9%) – two of the best-performing countries of the boom period (2003-2008), whose rates of growth have slowed measurably since. The growing index weights of the ‘top 4’ have had the effect of squeezing down exposure to other emerging countries, such as Mexico, Malaysia and South Africa. This index concentration presents a much more serious challenge to passive investors than it does active investors, the latter of which can underweight and overweight exposure to countries, sectors and stocks based on fundamental research that takes account of market and stock specific factors.

Emerging markets: more than just faster growth

Investing successfully in emerging markets is about more than simple economic growth. Over the medium-to-longer term, there does appear to be a relationship between economic growth and stock market performance but it’s not straightforward. The highest economic growth rates do not automatically translate to the best stock market returns, particularly in the short term. A host of other factors such as company fundamentals, stock valuations, macroeconomic and regulatory conditions, corporate governance and investors’ expectations all play their part. This complexity demands a diversified, stock-picking approach to emerging markets that focuses on a range of bottom-up factors over a simple focus on growth rates.

The importance of good governance

As the macroeconomic drivers that provided a tailwind to emerging economies in the last decade recede, the importance of fundamental stock drivers reasserts itself. Issues such as capital discipline, dividend policy, strategic management capability and corporate governance are becoming increasingly important for investors in emerging markets in the post-financial crisis world.  As chart 5 shows, the dominant driver of returns is stock selection, although the contribution of country selection to returns is higher in emerging markets than it is in developed markets. This supports a focus on research-driven, bottom-up managers.

Active managers following a bottom-up approach seek to invest in businesses that achieve superior and sustainable returns on their assets, and who pass those returns onto their minority shareholders through capital appreciation or dividend payments. This ensures that the companies invested in are inherently profitable enough to fund their development without putting investors at risk of default or dilution.

How active is your manager?

Active management within emerging markets has been proven to add value over time, whereas the performance of the median passive manager (including transaction costs and fees), produces returns slightly lower than the index. Studies suggest that approximately 80 per cent of active strategies have outperformed the MSCI Emerging Markets Index over the last ten years; the top 25 per cent outperformed by more than 3 per cent per annum, comfortably covering their fees.

However, the key question is how to identify better than average active managers? Academic research by Martijn Cremers and Antti Petajisto suggests it is down to the level of activeness. Not only do truly active managers outperform (after fees) but they tend do so persistently. Critically, it is possible to identify these managers by looking at how active they are, how much they cost and how well they have performed in the past. A paper by Intersec Research that compensates for survivorship bias suggests the value of active management also builds over time (and across market cycles).

To ascertain how active a fund manager is we can look at how different they are from the benchmark index. This can be measured using ‘Active share’ (or ‘active money’), which is the sum of all of a manager’s overweight positions plus cash, expressed as a percentage of the portfolio’s net assets. It is a measure of how much the portfolio’s composition differs from that of the index (i.e. how active the fund is).

‘Active expense ratio’ takes the approach a step further and is a measure of how active a fund is relative to its cost. The measure provides a useful way for investors to compare active managers and identify those who are genuinely active and value for money on that basis.6 Skilled portfolio managers who operate with high active money combined with reasonable TERs (resulting in a low active expense ratio) have the best scope to outperform after fees (see table 2 below).

TABLE 2. Source: *Average TER: Lipper IM, Lipper Global Offshore Equity Emerging Markets Global. Average Active Money: Morningstar GIFS Global Emerging Markets Equity. The passive expense ratio is assumed to be 0.70, in line with actual observed passive TERs. Active expense ratio = Passive expense ratio + (Portfolio expense ratio – Passive expense ratio/Portfolio active money). **Active money will typically range from 0.70 to 0.90.The lower the active expense ratio, the better.

Conclusion

The emerging market story is becoming more diverse and layered, forcing investors to become more selective than before. The factors that supported the synchronised growth of emerging markets and their brief mistreatment as a ‘homogenous’ bloc are fading.

It is a mistake to believe that China’s rebalancing process will be a negative for emerging markets generally. It will simply create greater differentiation between winners and losers. The heterogeneity of emerging markets will once again come to the fore, rendering terms like BRICs outmoded for investors who want dynamic exposures to a range of markets. This is not time to take money off the table – in fact, emerging market valuations are now attractive relative to history and compared to developed markets (see appendix).

It is, however, time to change tack as to how money is invested. Investors must always try to look forward, and avoid the temptation to use recent history as a roadmap for the future. With emerging market indices exposed to material concentration risks in some of the areas most vulnerable to economic rebalancing, it is vital investors take an active and forward-looking approach.

Given the re-emergence of the business cycle and specific risks relating to corporate governance and other factors, investors should also pay particular attention to the investment style of their manager. Can they weather ‘down periods’? Do they focus on quality, well governed growth or growth at all costs? Those managers with a proven ability to take account of important qualitative and bottom-up factors such as corporate governance, ownership structure and management strategy should be well placed to serve their investors over the next decade.

Nick Armet, Investment Commentator at Fidelity

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