Month: July 2017

Emerging Market Portfolio Managers Against the ETFs

In the world of emerging markets it has generally been presumed that managers can justify higher fees for this asset class because they add more value. It is argued that emerging markets are less efficient because they are complex and under-followed by professional investors.  The relatively scarce qualified portfolio managers and analysts with the skills and experience to navigate the territory should command higher compensation.

While low-cost indexed products have increasingly disrupted the asset management industry, the arguments in favor of active management for the emerging markets asset class have persisted: (Bloomberg)

  • Market inefficiency – More complexity and less professional analysis gives a tangible advantage to managers capable of conducting in-depth research.
  • Benchmark composition – The index benchmark is full of unattractive countries, sectors and companies, that can be avoided by skilled managers. For example, heavy index weightings in poorly managed state enterprises and commodity producers can be avoided to outperform.

Moreover, EM managers may have the advantage that because of its relatively short history as an asset class less academic research has been conducted on performance factors. While in the U.S. academic research has identified the performance “anomalies” caused by tilting portfolios for value, size, quality and momentum, these factors are less well understood in EM and may be easier to exploit by managers.

The evidence partially supports the argument that professional managers of emerging markets funds add value, at least in comparison to managers of U.S. domestic and international funds.

For example, the table below shows the latest results of Morningstar’s Active/Passive Barometer (Morningstar ). Active EM managers, despite higher fees, are seen to perform better than their peers in U.S. and International asset classes, with particularly impressive results over the three and five year periods. On an asset weighted basis, which gives greater consideration to the larger funds, performance is even better. (Note, the data does not consider the greater tax efficiency and lower acquisition costs for ETFs).

The SPIVA Scorecard published annually by S&P Dow Jones Indices (S&P Indices)  shows much less impressive results for EM active managers. SPIVA claims to have a more rigorous approach, adjusting results for survivor bias and for style (e.g., growth vs. value). The SPIVA scorecard shows EM active funds under-performing indices over all periods, largely in a fashion similar to U.S. and International funds. As with Morningstar, SPIVA shows larger managers with better results.

Part of the discrepancy between SPIVA and Morningstar can be explained by the significantly stronger performance of the S&P/IFCI EM Index used by SPIVA compared to the ETF composite used by Morningstar. This causes confusion as both ETFs and active funds use various indices, and neither study adjusts for this. In any case, both reports agree on several points. First, active managers have not created value over the long term; second, larger asset managers create more value. The better performance of the larger funds may show that larger managers with greater analytical resources can add more value.

The Morningstar report also points out that the primary source of outperformance relative to peers for active managers is lower fees. This may also explain the better performance of the larger managers, assuming that they are passing on the benefits of scale economies to clients.

Certainly, the disruptive influence of EM indexed products will not go away and may worsen. It may be that EM active managers have benefited of late from the bear market of the past five years for several reasons. First, during down markets active managers benefit from holding cash. This becomes a source of performance drag during bull markets, and we may have already seen this effect during 2016. Furthermore, assuming positive performance for EM equities, indexed products are likely to be more formidable competitors in coming years, as they tend to outperform in bull markets.

Index products should be easier to beat in a five-year bear market for EM like the one we saw between 2011-2016. The benchmarks which most active managers as well as ETFs observe are market cap-weighted indices, which makes them classic trend-following instruments. When markets are rising and flows are abundant, the index keeps on increasing position sizes in winners and reducing positions in laggards. This led to huge positions in commodity stocks in 2006-2007 and to very high weightings in tech companies today. During bull markets, most active investors become nervous about valuations and the size of positions and retreat ahead of the indices. In a bear market the process reverses. The index pressures prices by selling its largest most overvalued positions. The collapse of commodity stocks during 2012-2014 created “easy alpha” for managers who were comfortable in stepping aside and waiting for valuations to return to normal levels.

The dilemma for EM managers is the same faced by managers in all asset classes disrupted by low-cost index funds. To justify their existence managers have to take much more risk than they are comfortable with. The vast majority of professionally managed funds can be considered “closet index funds” in the sense that they manage around the index. The difference between the portfolio and the index is known as the “active risk.”  Many actively managed funds will have around 15% of active risk, the remainder of the portfolio mimicking the benchmark. The problem is that an ETF like Vanguard’s VWO, charges a management fee of only 14 basis points (0.14%), while the active manager charges, on average, 1.5%  even though  85% of his assets only mimic the benchmark. Clearly identifying this issue, a firm like Blackrock, which manages both ETFs and active funds, is moving aggressively into highly concentrated actively managed portfolios with very high levels of active risk.

However, moving to highly concentrated portfolios with high active risk is something that very few managers can countenance. AS GMO’s Jeremy Grantham  never tires of saying, the primary behavior driver of asset managers is career risk ( GMO ). Unfortunately, the proliferation of low-cost alternatives is undermining the economics of the asset management industry and decreasing job security just at the time that managers need to embrace risk.

Us Fed watch:

India Watch:

  •  Indian market can triple over the next five years (Wisdom Tree)

China Watch:

China Technology Watch:

  • China outlines plans to be world leader in AI (Caixing Global)
  • Lenovo announces big push into AI (SCMP)

Technology Watch:

  • The return of basic sewing manufacuring to the U.S. ((FT)
  • Are robots the future of global finance (UBS)

EM Investor Watch:

  • Emerging Markets rally has “legs” (Van Eck)
  • Revisiting Allocation decisions in EM (GMO)
  • EM  breaks 10-year downtrend (The Reformed Broker)
  • The bullish case for EM (Mark Dow)
  • EM ETFs don’t all track the same index (ETF.com)

Investor Watch:

Notable Quotes: (Avondale)

 

Emerging markets have been weak for a long time: “since the financial crises, interest rates, currencies etcetera, we’ve had a prolonged period of about eight, nine years now where we have seen significant weakening of emerging market currencies…you actually see the volume component of these emerging markets continuing to be very, very low, while historically it was all volume-driven growth. I am convinced that that is coming back now.” —Unilever CEO Paul Polman (Packaged Goods)

China may be stabilizing: “China for example is actually much more stable than the last 12 to 18 months. I like what I’m seeing in China right now.” —Abbott CEO Miles White (Medical Device)

Chinese are still buying international assets: “we’re still seeing the trend of Chinese buying and international assets. ” —Goldman Sachs CFO Martin Chavez (Investment Bank)

“In the vast majority of asset classes, prospective returns are just about the lowest they have ever been,” Howard Marks (Oaktree Capital).

Notable Chart:

In Emerging Markets The Only Constant is Change

Antoine van Agtmael, the man who coined the term “emerging markets,” was a pioneer. His firm Emerging Markets Management was founded in 1988 to provide institutions access to what was at that time a very small emerging markets asset class, with fewer than 20 companies with revenues over $1 billion, almost all of them either banks or commodity producers. In his book, The Emerging Markets Century (2007), van Agtmael stressed the violent pace of change for the asset class. Fifteen years after launching the fund, 80% of the largest 100 companies had disappeared from the list. Not one of the top ten most valuable stocks remained 15 years later. Several factors drove this revolution, according to van Agtmael.

  • The move of China, Russia and Eastern Europe from centrally-planned to market-oriented economies and their integration into the global economy through trade and investments.
  • A neo-liberal wave of privatizations across emerging markets, leading to private investment in energy, telephone and power companies and a wave of public listings.
  • Improved economic policies and lower tariffs (The Washington Consensus), resulting in the control of hyperinflation in Argentina and Brazil, fiscal discipline and deleveraging in Asia and trade expansion.

The chart below  lists the top ten most valuable emerging market stocks in 1990 and 2005, taken from van Agtmael’s book. I have added the current standings, as of July 2017.

 

These lists give us several valuable insights on emerging markets investing.

  • Change is constant. The “revolution” continues. The 1990 list was dominated by Taiwan which was at the top of an epic stock market bubble. The 2005 list is dominated by commodity stocks, propped up by the China-induced commodity bubble. The current list is all China and tech. Emerging markets have their own version of FANG (Facebook, Apple, Netflix, Google), which is BATS (Baidu, Alibaba, Tencent, Samsung).
  • The drivers cited by van Agtmael have lost traction. We are seeing a backlash against neo-liberal reforms and globalization, and few privatizations. Countries with large domestic markets to protect and exploit are now seen to have the advantage.
  • Bubbles in specific geographies or segments can have a huge impact on performance. The 1990 list coincides with the peak of the great Taiwan bubble. Bubbles in Mexico (1992), Malaysia (1996), Brazil (1997), Korea (2005) had similar distortionary effects on the rankings. Same for the  commodity bubble (2005-2010), which rules the 2005 list. The 2017 list is greatly impacted by the current boom in tech stocks. There seems to always be a major bubble brewing somewhere in emerging markets.
  • There are fewer changes between the 2017 list and the 2005 list than there were between 2005 and 1990, with four stocks remaining on the list. All of the surviving stocks are either China or tech related, which may indicate we are seeing long-term secular shifts happening.
  • The expansion of China in general and China and tech in particular seem inexorable. Or are they? Only time will tell. Of the 2017 top ten, eight are essentially Chinese stocks, as Naspers’s value is mainly in its holdings in Tencent and Hon Hai’s operations are mainly based in China. Only Samsung and TSMC are independent of China. China’s market weight is likely to grow further, as its economy grows above the global average and benchmark indices include more Chinese stocks.
  • India’s absence is noteworthy. If the current hype on India is justified, ten years from now we will likely see a few Indian names on the list.

 

Us Fed watch:

Brazil Watch :

India Watch:

  • The Indian economy; a tale of two narratives (Livemint)
  •  Indian market can triple over the next five years (Wisdom Tree)

China Watch:

  • China broad credit growth slows to zero (Variant Perception)
  • Making sense of China’s foreign M&A (McKinsey)
  • Zombies are dragging down China’s productivity (Bloomberg)
  • The CEO guide to China (McKinsey)
  • The Chinese bought $32 billion in U.S. residential real estate in 2016 (WSJ)
  • Xi’s Tiger Hunt (Sinocism)

China Technology Watch:

  • Chinese military drones gaining foreign markets at U.S. expense (WSJ)
  • JD.COM invests in drone delivery (China Daily)

China Consumer Watch:

  • Chinese have all the appliances they need (SCMP)
  • China’s Hisense wins sponsorship for FIFA 2018 (China Daily)

Eastern Europe Watch:

  • Poland is breaking out of the Middle-Income Trap (NY Times)

Technology Watch:

  • The return of basic sewing manufacuring to the U.S. ((FT)
  • Are robots the future of global finance (UBS)

EM Investor Watch:

Investor Watch:

Notable Charts:

 

Learning to Love Volatility in Emerging Markets

Though economic and currency volatility may reduce the long-term sustainable GDP growth of countries like Brazil ( Brazil’s Economic Stagnation), paradoxically,  volatility is also the primary source of returns for the emerging markets investor. Economic booms, with rising stock markets and strengthening currencies, are invariably followed by busts, with collapsing markets and weaker currencies. For the investor who measures returns in dollar terms, the more volatile emerging markets provide turbo-charged results both on the way up and the way down. Learning to love that volatility is often the key to success.

Brazil is one stock market that is marked by enormous swings. Since 1990 Brazil has seen three market collapses; -88% in 1997, -76% in 2008, and -88% in 2011 (all measured in USD terms). Brazil also had a 80% collapse in the seventies and an 88% drawdown concluding in 1990. It seems that about once a decade, a period that should be well within a reasonable time horizon for most investors,  an investor in Brazil suffers  losses of between 80-90% in terms of U.S. dollars.. But Brazil is far from being unique in emerging markets in this regard. Since 1990, there have been 41 cases of a stock markets losing more than 50% of their value, with an average drawdown of 72%. Over this period, Turkey and Argentina are the champs, each experiencing six drawdowns of over 50%.

On the positive side, drawdowns are followed by bull markets, like day follows night. Over the next two and half years following the 41 market bottoms, investor see average returns of over 500%. Every Brazilian collapse has been followed by a extraordinary bull market:

  • 1983 bottom (-80%), followed by 14x return of capital
  • 1991 bottom (-87%), followed by 24x return of capital
  • 2002 bottom (-83%), followed by 17x return of capital

For the value investor, the brutality and frequency of emerging market drawdowns creates a dilemma. Value investors, indoctrinated by Warren Buffett’s consistent wisdom, believe in investing for the long-term. For example, two commonly cited quotes from Buffett are:

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 year;”

And “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”

An emerging markets investor could follow Buffet’s advice, patiently sitting through the drawdowns. By sticking with only the highest quality companies, the drawdowns can be minimized. The astute investor can also improve returns by trimming positions when valuations are high and taking advantage of market meltdowns to add to positions.

However, an alternative and often more productive better way to invest in emerging markets is to learn to love the volatility and skillfully harness it as the major source of returns.  Emerging markets, like commodities, often experience extreme cyclicality with predictable patterns. Investors that are aware of the patterns, can exploit them repeatedly. As commodity markets investor Martin Katusa says, investors in markets characterized by extreme cyclicality can best be “be approached with a ‘rent, don’t own” mentality.”

A strategy which may be anathema to value investors but is very effective in emerging markets and commodity investing is to marry a valuation process with basic trend-following techniques. An investor can patiently wait for a market to meltdown and then watch like a hawk for an entry point to ride the inevitable bounce-back. Typically, good entry points are created when a market has reached extraordinarily low valuations and is showing signs of trending up. Market bottom valuations, in my view, are often signaled by cyclically adjusted price/earnings ratios (like the CAPE Schiller ratio), which should be dollarized to fully measure the volatility of the markets. Timing decisions can be influenced by simple trend-following indicators, like the 50-day or 200-day moving average.

The advantage of patiently waiting for markets to bounce back before deploying capital is that the investor does not experience massive losses of capital on the downside. The absolute investor without concern for benchmarks is in a better position to do this than most institutional investors who are not willing or permitted to stray from their benchmarks for long periods of time.

Us Fed watch:

Brazil Watch :

  • China’s Fosun looking at Brazil Healthcare (SCMP)
  • IMF On Latin America Currency Flexibility ( IMF)

Mexico Watch:

  • WEF Tourism Competitiveness Report shows Mexico’s Rise (WEFORUM)
  • Mexico’s surprising oil finds (NY Times)

India Watch:

China Watch:

  • Mark Mobius on China  (Templeton)
  • Beijing’s New Airport (Caixing)
  • Xi Jinping’s War on Financial Crocodiles (FT)

China Technology Watch:

  • Chinese train maker expands U.S. market  (China Daily) 
  • China Launches new generation bullet train (WIC)
  • Beijing Subway Blocks ApplePay WIC
  • JD.COM invests in drone delivery (China Daily)
  • China plans $108 BB investments in chips (WSJ)

China Consumer Watch:

  • China’s Hisense wins sponsorship for FIFA 2018 (China Daily)
  • China rises in global tourism competitiveness (China Daily)

Korea Watch:

Eastern Europe Watch:

  • Poland is breaking out of the Middle-Income Trap (NY Times)

Commodity Watch:

  • Oil’s Game of Chicken; Can OPEC Finally Bankrupt U.S. Production (Seeking Alpha)

Anti-Globalization Watch:

Emerging Markets Investor Watch:

Guru Watch:

  • An Interview with Peter Bernstein (Jason Zweig)
  • Chano’s sees weak U.S. economy (Inetenomics)Notable Charts:
  • China Inverted yield Curve signals slowdown
  • Commodities at record low valuations relative to the S&P 500

Notable Quotes:

  • When markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.” (Bob Rodriguez – We are witnessing the development of a “perfect storm”(seeking alpha)

“Stock prices are likely to be among the prices that are relatively vulnerable to purely social movements because there is no accepted theory by which to understand the worth of stocks….investors have no model or at best a very incomplete model of behavior of prices, dividend, or earnings, of speculative assets.” (Robert Schiller)

 

 

 

 

 

 

 

 

 

 

 

 

Brazil’s Economic Stagnation

Brazil is a poster child for the “middle-income trap,” the phenomenon that keeps developing economies from narrowing the wealth gap with wealthy countries once they have reached a moderate level of prosperity. As is typical for many emerging market countries which are over-dependent on commodity exports and foreign capital inflows, the Brazilian economy experiences frequent boom-to-bust cycles, the latest being the commodity/liquidity/credit-fueled consumption boom of 2003- 2013 which was followed by a deep recession in 2014-2017. The overall result is mediocre growth. Brazil’s GPD per capita relative to the high-income economies is at the same level as in 1960, and actually has deteriorated significantly since the late 1970s.

A recent paper by Jorge Arbache and Sarquis J. B. Sarquis, Growth Volatility and Economic Growth in Brazil (Arbache-Sarquis) argues that Brazil’s poor performance is tied to the high volatility of the economy which in turn is caused by uncertain commodity prices and capital flows and their effects on currency valuation. It makes intuitive sense that volatility would hurt growth; boom-to-bust cycles are inefficient, as economic agents over-indulge in good times and retreat in bad times. Volatility also makes it difficult for both the public and private sector to plan and budget long term investments.

Brazil’s economic volatility is caused by well-known factors:

  • Chronic low savings and high current account deficits financed by fickle foreign capital flows.
  • Exports dominated by commodities, and the current account highly impacted by commodity prices. High commodity prices improve the current account which lowers country risk premia and leads to higher foreign financial and investment When commodity prices fall, the process unwinds.
  • Pro-cyclical currency valuation. The currency appreciates during good times and weakens during busts. During currency appreciations manufacturers lose export competitiveness and focus on growing domestic consumption.
  • Monetary policies dictated by the U.S. Fed. The deep recession of 1981-83 was triggered by U.S. Fed Volcker’s high interest rates imposed to wage his war on inflation. The boom of the last decade was fueled by Fed-fueled global liquidity.
  • Pro-cyclical fiscal and monetary policies; fiscal expansion during booms and retraction during busts. During the current deep recession in Brazil, the authorities have both increased real interest rates and tightened fiscal spending.
  • Chronic fiscal imbalances cause uncertainty and high country risk premia.

The current boom-bust cycle has been particularly destructive for Brazil. The china-induced commodity boom caused excessive currency appreciation, a credit-fueled consumption surge and severe deindustrialization.  In sharp contrast to successful Asian economies that have promoted the exports of manufactured goods, Brazil has evolved prematurely into a service economy. 76% of jobs in the Brazilian economy are now generated by the service sector, and the great majority of these jobs are low-skill, low wage jobs. Manufacturing’s share of GDP has fallen from 34% in 1980 to 10% in 2015, and Brazil has become increasingly dependent on commodity exports.

Brazil’s Central Bank has pursued inflation-targeting, the latest fashion for global monetary authorities, with abandon. During the past decade and especially the past three years of deep recession, Brazil has consistently had the highest real interest rates in the world. The famous dictum voiced by former Finance Minister Mario Henrique Simonsen  — “A inflação incomoda, mas o câmbio mata (Inflation bothers but the foreign exchange rate kills.“ ) has been entirely forgotten.

How can Brazil avoid boom-bust cycles in the future? As Arbache and Sarquis state in their paper, given Brazil’s history it is better to aim to grow in a stable and sustained manner than to seek high rates of growth. Solving chronic fiscal and foreign account imbalances are at the center of any reduction in volatility. On the foreign account side, it would be imperative for Brazil to maintain a competitive currency to promote domestic manufacturing and gradually diversify from commodities.

However, Brazil’s poor economic performance is only partially explained by volatility. More importantly, Brazil does poorly in human capital development and in providing a good environment for business. Steady improvement in both these areas would boost sustainable growth. Unfortunately, Brazil has shown no progress in these areas. Its ranking in the United Nations Human Development Index has fallen from 69 to 79 over the past 15 years. Ditto for the World Bank’s Doing Business survey which ranks countries in terms of the quality of the regulatory and institutional framework for business and where Brazil has shown no progress whatsoever.  Brazil ranks a miserable 123rd on the list, lower than 119 in 2006, and the worst performing of the major emerging markets except for India.

 

Us Fed watch:

Brazil Watch :

India Watch :

China Watch:

  • Beijing’s New Airport (Caixing)
  • Xi Jinping’s War on Financial Crocodiles (FT)

China Technology Watch:

  • China aims to be a leader in 5G  technology (WIC)
  • China Shows off New Generation of High-Speed Trains (Caixin)
  • CRRC Wins Train Supply Deal in Montreal (Caixin)
  • Chinese Phones Take over Indian Market (SCMP)

China Consumer Watch:

  • China’s aging (Bloomberg)
  • P&G Refocuses Strategy on Premiumisation ( SCMP)

Eastern Europe Watch:

Poland is breaking out of the Middle-Income Trap (NY Times)

Commodity Watch:

  • Oil’s Game of Chicken; Can OPEC Finally Bankrupt U.S. Production (Seeking Alpha)
  • Will U.S. Drillers Drive Oil Prices Into the Ground (Fed Up)
  • Temasek on Chinese Overinvestment (CNBC.com)
  •  China’s Steel Overcapacity (Peterson Institute)

Technology Disruption Watch:

Anti-Globalization Watch:

Emerging Markets Investor Watch:

Notable Blogs:

Notable Quotes:

“The biggest unknowable is that you have the illusion of liquidity. You have people who promise overnight liquidity that have taken quite illiquid positions, particularly lending to various entities. As long as the party continues that’s fine, but should this liquidity be tested it’s not going to be as deep as people think.” – Mohamed El-Erian

“When the markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.” (Bob Rodriguez – We are witnessing the development of a “perfect storm”(seeking alpha)

“Stock prices are likely to be among the prices that are relatively vulnerable to purely social movements because there is no accepte theory by which to understand the worth of stocks….investors have no model or at best a very incomplete model of behavior of prices, dividend, or earnings, of speculative assets.” (Robert Schiller)