August 2019 – The Emerging Markets Investor

The long-term performance of U.S. actively managed mutual funds investing in emerging market equities has been problematic. This goes against the argument that emerging markets should provide more opportunities for skilled active investors because of greater market inefficiency. In fact, the ability of EM investors to provide results above their benchmarks has been in line with the experience of portfolio managers investing in the supposedly highly efficient U.S. markets for large capitalization stocks.

This disappointing reality is highlighted by a recent academic paper, “The performance of US-based emerging market mutual funds,” (Halil Kiymaz and Koray D. Simsek Rollins College – Crummer Graduate School of Business) (Link).

Kiymaz and Simsek looked at actively managed U.S. mutual funds classified as “Diversified Emerging Markets” during the January 2000 to May 2017 period, admittedly a relatively short period. They identified 222 specific mutual funds active over this period. The researchers did not adjust the results for style mandates. In other words, “growth” managers were not judged relative to the “growth” benchmark, and “value” investors were not compared to the “value” index.

A summary of their findings follows:

Median and mean annualized returns were 4.17 and 4.87%, respectively. This indicates better performance for the larger asset managers, presumably because of larger research budgets. These returns compare to 6.65% and 7.89% for the two major benchmarks, the MSCI Emerging Markets and the S&P/IFC Emerging markets, respectively.
Fee expenses, though declining during the period, reduced returns by 1.22%, with no difference between the smaller and larger managers.
Cash was a significant drag on performance, with larger managers holding more cash than smaller ones. The mean cash holding over the period was a very high 9%.
The mean turnover (a measure of the amount of change in a portfolio in a given year) of the fund universe was a high 65%, and very likely another drag on performance. Surprisingly, larger managers had considerably higher turnover than smaller ones, which may imply significant market impact on stock transactions.
The average fund was heavily over-weighted in larger capitalization, “blue chip” stocks. Moreover, a “quality” bias can be seen in the relatively low volatility of returns: standard deviation of returns were 17.43% compared to 22.2% for the benchmarks.
The average tenure of the portfolio managers responsible for the funds was only 4.5 years; once again, the larger funds having more experienced hands on the tiller.

Conclusions

The Kiymaz-Simsek paper point to various short-comings of active managers. First, of course, management fees and transactions costs reduce significantly the potential returns of the investor in the funds; second, managers do not seek to exploit well-documented small-cap and liquidity premiums, preferring the comfort of investing in the best “quality,” largest and most liquid companies; third, managers hold excess amounts of cash in what is most-likely a futile attempt to time the market.

With the abundance of very low-cost ETFs replicating most strategies now available to investors, fund managers need to provide a genuine alternative. In all likelihood, successful strategies will have to embrace some of the following characteristics:

High portfolio “active risk,” an industry metric which measures how different a portfolio is from its benchmark.
Greater focus on under-followed segments of the markets, which implies a disciplined contrarian mentality and focus on less liquid and unpopular stocks, and lower turnover and longer holding periods.
Boutique structures with experienced managers.

Trade Wars

The great decoupling (Oxford Energy)
KKR sees opportunity in China decoupling (KKR)
Banning technology will backfire on the U.S. (FT)
A G-2 world (project syndicate)
Ian Bremmer (Aviva)
Post-dollar networks (project syndicate)
Investing in the age of deglobalization (FT)
Is American diplomacy with China dead? (AFSA)

India Watch

India’s digital transformation (McKinsey)

China Watch:

Expected returns in China (UBS)
China-Russia: cooperation in Central Asia (AsanForum)
China and the World (Mckinsey)
The China-Russia partnership (The Economist,Link))
Chinese internet weekly (seeking alpha)

China Technology

Inside China’s biopharma market (McKinsey)
China Internet Weekly (Seeking Alpha)
China’s food delivery war (Bloomberg)
How China took the lead in 5G technology (WP)
China’s MIC 2025 plans are roaring ahead (SCMP)
China’s EV future (The Econoist)
China’s EV bubble (Bloomberg)

Brazil Watch

Brazil-U.S. ties with Trump-Bolsonaro (The Dialogue)
The bear case for Brazil (seeking alpha)
Business optimism returns to Brazil (FT)
The great Brazilian foreign policy realignment (National Interest)

EM Investor Watch

Naspers strategy to create value (FT)
Latin America and Europe come closer (The Economist )
Another bad week in South Africa (The Economist )
The days of Erdogan may be over (Spiegel

Tech Watch

Investing in Asian Innovation (Oppenheimer)
Trends in battery prices (BNEF)
Mary Meeker’s Internet Trends report (techcrunch)
Germany is losing the battery war (Spiegel)
Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

The age of wealth accumulation is over (FT)
An investment thesis for the next decade (Gavekal)
Dalio on Diversification (Dalio)
AI Creates Strategic Dilemmas (FT)
Fooled by randomness (macro-ops)
The imperative for international diversification (Swedroe)
The end of sell-side research (Epsilon)
Understanding why currencies move (macro-ops)
EM value as an anti-bubble (research affiliates)

The Economist’s Big Mac Index ( Link ) looks at the dollar cost of a hamburger sold by McDonald’s restaurants in some 60 countries. The index shows a remarkable range of prices around the world. In the latest survey, the most expensive burger was found in Switzerland ($6.54) and the cheapest in Russia ($2.04). Presumably, these hamburgers are identical, with the same combination of bread, beef patty, lettuce and sauce. The price in each country should reflect the cost of the materials, labor and rent, profit margins and taxes. The index pretends to shed some light on the relative costs of doing business in different countries, and, given that it has been measured for some 30 years, it can also provide an indication of the evolution of business costs. Moreover, it can be used as a proxy to measure the relative competitiveness of currencies around the world.

The Big Mac data confirms the strength of the USD following a 8-year period of USD appreciation against both developed and emerging market currencies. EM currencies are inexpensive compared to the high levels of 2007-2011 and generally in line with long-term historical levels. Competitive currencies, low earnings multiples and higher GDP growth compared to the United States are the foundation for a positive outlook for EM stocks.

In terms of specific emerging market countries, the relative strength of the Brazilian real is noteworthy. The BRL is the most expensive EM Big Mac currency, which is curious given the depressed economy, current account deficit, low savings and low interest rates.

The data is detailed below for the primary EM countries of interest to investors.

It is important to view the data in a country-specific historical context to understand what the data means. We look below at several specific cases, and compare the data for the Big Mac Index with the Real Broad Effective Exchange Rate (RBEE) as measured by the Bank for International Settlements (BIS)

Brazil

The first thing to note is that the current relatively high valuation of the Brazilian real is not an anomaly. Except for a brief period in 2015, one has to go back to 2000-2004 to find a “cheap” real. The current “weakness” of the BRL appears largely explained by the strength of the dollar, which has appreciated against almost all currencies over the past eight years. The data is confirmed by the BIS RBEE data which shows the BRL to be about in line with its 25-year average. The BRL probably has some moderate potential for appreciation when the economy experiences a more robust economic recovery and will quickly find itself in overvalued territory, and impediment to trade and investment. The strong BRL is very difficult to reconcile with the Bolsonaro’s market-opening initiatives, such as the recent trade agreement with Europe.

Thailand, Chile, South Korea, and Colombia

The Thai Baht has been on a path of appreciation, driven mainly by capital inflows. This is reflected both in the Big Mac and RBEE data, and should be a major headwind for a country that relies on exports in an increasingly competitive market and in a region where most countries have kept their currencies very competitive. Chile, South Korea and Colombia all have currencies that are strong relative to other EM currencies but more-or-less neutrally positioned relative to their own histories.

Peru

The data on the Peruvian sol is confusing. The Big Mac Index shows a currency that has weakened well below its peak and appears to be at a competitive level. However, RBEE numbers point to significant overvaluation, near peak levels.

China

The Chinese yuan is on a long-term gradual appreciation path, in line with the growth and increased sophistication of economic output. This is confirmed by both the Big Mac and RBEE data. The recent dip in the yuan is a response to trade war tensions. Despite a burgeoning current account deficit and capital flight, Beijing appears committed to a stable yuan to further its gradual internationalization of the currency.

Turkey and Argentina

By any measure, the Turkish Lira is very undervalued. The Big Mac Index shows Turkey at record-lows both relative to its history and compared to other countries. This confirms by the RBEE which shows Turkey starting to rebound from near record-low levels. For an investor in Turkish assets, the very cheap lira should provide a strong boost to total dollar returns when the economy recovers over 2020-2022.

The same goes for Argentina. The peso is cheap by any measure and should provide support for asset prices if politics do not get in the way. Argentina is much better positioned to benefit from free-trade deals than Brazil.

Russia

Russia provides an interesting contrast to Turkey. Though the Russia Big Mac is very cheap, it is only marginally cheaper than it has been for the past 20 years both relative to the USD and to other countries. The BIS RBEE shows that the ruble is only cheap relative to the peak of the 2008-2012 commodity boom but in line relative to history. This points to moderate upside for the ruble, unless, of course, oil prices rally strongly.

South Africa

In the same vein as Argentina, the rand is inexpensive by any measure and should provide support for asset prices, if politics and capital flight do not get in the way.

Malaysia and Taiwan

Both Malaysia and Taiwan are committed to maintaining their currencies at very competitive level, to support exports in an increasingly hostile world for small export-oriented countries.

Indonesia and the Philippines

Unlike Taiwan and Malaysia, Indonesia and the Philippines have allowed their currencies to appreciate, driven by capital inflows, though from a Big Mac basis they are in line with history.

India

The rupee is on an a gradual appreciation trend. The rupee is likely to trade increasingly in line with oil prices as the country has become the biggest importer of oil in the world. Currency strength is not likely to be a boost to investor performance from current levels, unless oil prices collapse.

Mexico

The Mexican peso is very cheap, but on a downward trend. AMLO’s policies are driving both foreign and domestic capital out of Mexico while Trump unsettles investors with trade tensions.