October 2019 – The Emerging Markets Investor

The Chilean Riots and the Privatization of Public Goods

The recent riots in Chile, triggered by a small increase in the subway fare, have highlighted the politically explosiveness of the pricing of “public goods,” particularly in societies with high wealth concentration.

The root cause of the Chilean riots appears to be a strong conviction held by the main population that the “system” is rigged in favor of the elites and will not provide the most basic public goods necessary for anyone to have a fair shake at improving one’s lot.

For a major metropolitan area like Santiago this means an efficient subway system to transport the less-well-off from the distant suburbs to the jobs in the prosperous city center. The Santiago Metro does this pretty well. But, ironically, having a good subway system causes new issues, such as making the poor much more aware of wealth disparities, and making them highly dependent on continued access to maintain their jobs. Apparently, even small increases in fares can be very unsettling for workers and students living in precarious situations.

This raises the question of what role the government should play in providing public goods and how to pay for them. This is a huge dilemma everywhere but especially in Latin America where government finances have historically been poorly managed and debt levels are high. Over the past decades, governments have pretended they could dismiss the problem by turning to privatization and “high finance”: public companies financed in the bond market and concessions. This is the case, for example of the Santiago Metro, which is a corporation with close ties to the Chilean capital markets.

This abdication of the responsibility for investment in public goods has increasingly become the norm in many Latin American countries where most infrastructure (airports, highways,etc…) has been turned over to the private sector. Increasingly, this also applies to healthcare and higher education, where dysfunctional public institutions are hopeless.

The current government in Brazil is pursuing the most pro-markets policies that the country has seen since the 1960s. The finance minister, Paulo Guedes, would like to privatize and deregulate everything as fast as possible, hoping to spark an entrepreneurial revolution in the country.

But, this is the same country which was paralyzed by a truckers’s strike in 2018, in response to diesel and toll prices. President Bolsonaro’s honeymoon is over now, and as we have seen in Argentina, Chile, Hong Kong and elsewhere, patience is running thin.

Competitiveness in a Global Economy

Since 2004, The World Economic Forum (WEF), a Switzerland-based NGO with strong ties to the business community, has published the Global Competitiveness Report (GCR) which ranks countries on the basis of their ability to compete in the world economy. The report (Link) gives us a snapshot of where countries stand relative to their peers on a wide variety of measures, and long-term comparisons provide a good indication of which countries are taking the steps to improve their ability to compete and prosper.

The methodology of the GCR incorporates a wide variety of factors, but the focus is squarely on the quality of institutions and other “soft” elements, rather than on the quantity of capital and labor. The rankings purport to show which countries provide the best business environment to unleash the animal spirits of entrepreneurship and innovation.This may be a particularly useful approach in this day and age when increasingly growth seems to be driven by innovation and the other intangible forces that impact “total factor productivity.” Importantly, the report shies away from passing judgement on the pros-and-cons of democratic versus more authoritarian regimes, beyond what the immediate implications might be for business and development.

The CGR ranks each one of 144 countries according to 12 “pillars” of competitiveness:

Institutions
Appropriate infrastructure
Information and communication technology adoption
Macroeconomic stability
Health
Education and skills
Efficient goods markets
Efficient labor markets
Efficient financial markets
Market size
Business dynamism
Innovation capability

Each one of these pillars is explored in detail. The following chart shows the latest WEF, Global Competitiveness Rankings, with emerging markets highlighted in bold black and frontier markets in red.

The first quartile are mainly “Western” democracies, with Japan, Taiwan and Korea representing Asia. Two, non-democratic, authoritarian and dirigiste regimes –Singapore and UAE –also make this list.

The second quartile includes the remainder of the Western democracies (except for Greece), most of eastern Europe and the remaining Middle-East authoritarian states. This quartile of semi-competitive countries also includes China, Indonesia, Malaysia and Thailand in Asia and Chile and Mexico in Latin America. These countries range across the political spectrum, from highly authoritarian to fully democratic. China is very close to reaching elite status, and sees itself on the same path as Singapore.

The third quartile are countries with serious competitive issues this includes many core emerging markets such as Colombia, South Africa, Turkey, India and Brazil. This group’s political inclinations also range from dictatorships (Vietnam) to full democracies (Brazil).

The last quartile shown here (not including another 44 countries at the bottom of the rankings) are all severely impaired from a competitive aspect. This includes Argentina, Egypt and Pakistan in emerging markets and Bangladesh and Nigeria in frontier markets.

The next chart below shows the evolution of rankings over the past 10 years. The left side of the chart shows countries with improved or no change in ranking, while the right side shows countries with declining rankings. EM economies with either significant improvements or declines are highlighted in bold.

Non-competitive countries with declining rankings are those highlighted in the bottom of the right-hand side of the chart. These countries should be considered problematic for investors, and it is therefore no coincidence that these countries suffer from low investment and capital flight. This includes major economies and population centers that are of major concern to emerging markets investors – Brazil, India, South Africa, Nigeria, Egypt and Pakistan.

Trade Wars

The great decoupling (Oxford Energy)
KKR sees opportunity in China decoupling (KKR)
Banning technology will backfire on the U.S. (FT)

India Watch

Modi’s self-inflicted economic mess (project syndicate)
India’s digital transformation (McKinsey)

China Watch:

Expected returns in China (UBS)
China-Russia: cooperation in Central Asia (AsanForum)

China Technology

China phone sales now require face scan (venturebeat)
China’s Digital Economy (IMF)
China’s Digital Trends (McKinsey)
Interview with Alibaba’s CEO (McKinsey)
Inside China’s biopharma market (McKinsey)
China Internet Weekly (Seeking Alpha)

Brazil Watch

Brazil-U.S. ties with Trump-Bolsonaro (The Dialogue)
The bear case for Brazil (seeking alpha)

EM Investor Watch

The open secret of development (project syndicate)
IMF, Global Financial Stability Report (IMF)
Russia, the cheapest market in the world (seeking alpha)
Global Competitiveness report 2019 (WEF)
Naspers strategy to create value (FT)

Tech Watch

Risks and opportunities in the battery supply chain (squarespace)
Investing in Asian Innovation (Oppenheimer)
Trends in battery prices (BNEF)

Investing

Larry Hite on trend following (marketwatch)
Ten years of performance is still just noise (Swedroe)
Joe Greenblatt on value investing (wsj)
The correlation between stocks and bonds (Axioma)
A taxonomy of moats (reaction wheel)
An investment thesis for the next decade (Gavekal)

A Primer on Emerging Market ETFs

In many ways investors have never had it so good. Since last week practically the entire U.S. brokerage industry has gone to zero commissions for stock trades. At the same time, the most prominent ETFs (exchange traded funds), which are ideal building blocks for any allocation strategy, are charging minuscule management fees. This means that a millennial investor today can build his wealth without incurring any transaction costs. Compare this baby-boomers who accumulated savings while paying fees to financial service firms of 1-2% per year on assets.

This gradual disruption of the revenue base of the investment industry has occurred over the past 30 years, through the concurrent rise of discount brokers (e.g. Charles Shwabb) and low cost indexing strategies (initially driven by Vanguard mutual funds and later by ETFs). All of these changes are driven by computer automation and scale. In recent years, the trend has accelerated. JPMorgan estimates that today 90% of U.S. equity trading volume comes from computer-driven systematic trading accounts, leaving 10% in the hands of discretionary traders.

This disruption in some ways is even more profound in emerging markets where transaction fees have historically been much higher than in developed markets. ETFs are allowing investors to largely bypass the high costs of investing in local markets because the great majority of trades can be settled internally within the funds, and only marginal increases/decreases in assets have to be funded externally. (e.g. EWZ, the Ishares Brazil ETF now settles daily within its own structure about the same volume as Brazil’s Bovespa index.) Moreover, emerging market asset managers in the past had been able to charge high management fees, typically in the 1.5-3.0% range, and even today very high fees remain the norm in most domestic markets. However, today any investor can get broad global emerging market exposure through ETFs for an annual fee of 11 basis point (0.11%) and Franklin Templeton is offering a suite of country funds with annual expenses of 19 basis points (0.19%). When the first country funds where launched in the 1990s they had expense ratios of 2.5-3%.

The result is that emerging markets, like other asset classes, have come to be dominated by low cost indexed products sold in the form of ETFs and mutual funds. These funds which are computer driven and rules-based are said to be “passively” managed in contrast to “actively” managed funds where discretionary decisions are taken by managers on the basis of fundamental analysis. Passively managed products can charge very low fees because they are run systematically by computers, and as scale rises and computer costs decline they can continuously cut expenses further.

In the U.S. market alone, there are currently over 250 ETFs investing in emerging markets, with total assets of $250 billion. Including mutual funds, there are approximately $500 billion invested in EM assets in the U.S. market, of which about 60% of the total is invested passively. This compares to a 60/40 mix in favor of actively managed funds just five years ago, which shows how rapidly the industry is changing.

To get an idea of the characteristics of the passively-managed universe in emerging markets, we can look at the data provided by the website ETF.com.

The chart below shows the 20 largest EM ETFs as of September 30 of this year. There are several points that we can highlight:

The EM ETF world is already highly concentrated. The battle for this space was won in the early stages by Blackrock and Vanguard. 87% of all EM ETF assets are held by the twenty largest ETFs, of which 60% and 30% are in the hands of Blackrock and Vanguard, respectively. Charles Schwab, though a late comer, has successfully used its distribution power to become a significant third force.. All the remaining players have niche strategies, but most lack differentiation and scale. Not surprisingly, rumors abound of M&A activity to promote further consolidation.
The space is very dominated by basic global emerging markets (GEM) index products: Blackrock’s IEMG (MSCI EM) and Vanguard’s VWO (FTSE EM). The fees for these products have plummeted; in fact Blackrock’s initial GEM product, EEM, now slowly dissipates because of its “exorbitant” 0.67% expense ratio, compared to IEMG’s 0.14%. The cheapest GEM fund is now State Street’s SPEM (S&P EM), with a fee of 0.11%.
To lower expenses and remain competitive there is a broad trend for smaller firms to develop their own indexes.
With relentless pressure on fees, industry asset-gatherers need to be creative to differentiate products from the basic GEM funds. Based on the complexity and marketing attractiveness of these differentiated strategies, fund companies aspire to secure higher fees.

GEM Plus Funds

The most basic differentiation strategies are “GEM Plus” funds where the manager has introduced a tweak to the basic GEM product which is deemed to be of interest to investors. These include the following:

- RAFI Products – These funds, based on the Research Affiliates Fundamental Index, weigh stocks on the basis of fundamental characteristics (sales, cash flow, dividends and book value) in contrast to the market capitalization weights that are the rule for the big GEM funds. This provides investors with a “value” tilt, and periodic rebalancing to harvest mean reversion. The funds using the RAFI index are currently charging between 39-60 basis points, a large premium over the standard GEM funds.
- GEM with Exclusions – These funds charge a moderate fee premium of 5-20 basis points and many keep their costs down by creating their own indexes:
  - - GEM minus China.
    - GEM minus state-owned companies
    - GEM minus stocks which violate ESG (environmental, social and governance) standards.

“Smart-Beta” Funds

The next area of differentiation is with the so-called “smart-beta” products. These funds seek to exploit academically recognized investment factors (value, growth, small cap, quality, income, momentum) which historically have provided higher returns. These funds can be divided into those that focus on only one factor and those that combine multiple factors into their algorithm. In recent years, a wave of multifactor products have hit the market, most of which use a combination of factors deemed to provide benefits of diversification and non-correlation. Single-factor funds currently tend to charge fees between 30-50 basis points, while multi-factor funds tend to gravitate towards the high end of that range with some closer to 60 basis points.

Country and Regional Funds

Another area of great importance for ETFs are country and regional funds. Single-country products have always found traction with investors, and some country funds have been around for decades, first in the form of mutual funds and now largely as ETFs. Many of these products enjoy legacy fees which range between 50-70 basis points which they can sustain because of their strong market presence. This segment is firmly dominated by Blackrock’s Ishares funds. Both Van Eck and WisdomTree have had some success by entering niche products and developing their own indexes. Franklin Templeton is the latest entrant in this space with its suite of low cost country funds (19 basis points) indexed to FTSE, but so far it has had limited success.

Sector Funds

Finally, sector funds are a poorly developed segment of the market. On a global basis, only a few funds have been launched, with the Ishares EM technology ETF (EMQQ) having had the most success. Several GEM consumer funds have also been launched by Columbia, WisdomTree and Kraneshares. These funds have high expenses (50-90 basis points). EMQQ currently charges 86 basis points.

An entire suite of China sector funds has recently been launched by Mirae, so far with limited success. These funds have 65 basis points of expenses.

The following chart summarizes the data for the EM ETF Universe. The first column shows the percentage total assets in each major segment and the second column shows the fee expense ratios for each segment.

	% of Total Assets in Each Segment	Average Annual Fee
Gem	65.43%	0.23%
Fixed Income	11.09%	0.38%
Country/Regional	16.82%	0.64%
One Factor	4.07%	0.38%
Multi-Factor	2.59%	0.56%