July 2021 – The Emerging Markets Investor

AMLO’s Embrace of the United States

Mexico’s president Andres Manuel Lopez Obrador, popularly referred to as AMLO, is a quixotic figure, enthralled with the leftist ideals of the past and nostalgic for state-led economic growth. But, at the same time, unlike most of the traditional left, he is both socially and fiscally conservative. This leads him to assume seemingly contradictory positions. At heart a populist with a genuine preoccupation with the concerns of the poor, he dislikes debt and is a fiscal hawk ; and though he relishes fiery anti-American rhetoric, as president he has pursued pragmatic and cordial relations with the U.S. and even embraced the shameless Mexico basher Donald Trump “as a friend of Mexico who respects our sovereignty.”

AMLO’s contradictions were in full view in an important speech he delivered July 24 at the Castillo Chapultepec to commemorate the birthday of Simon Bolivar, the “libertador” of South America. Surrounded by diplomats and intellectuals from across Latin America, AMLO provided a whirlwind overview of Latin American history and centuries of oppression at the hands of Spain and the United States. The nefarious rule of the hegemon continues to this day and only glorious Cuba has successfully defied it, AMLO declared.

AMLO repeated the standard claim of the Latin American political left that all of the region’s problems have been caused by the United States. According to AMLO, it all started when Thomas Jefferson convinced President James Monroe that “the Americas are for the Americans” which led to the “disintegration of the peoples of our continent and destroying what was built by Bolivar.” Using military force and conducting overt and covert operations against independent countries, the U.S. has imposed its will in the region. Only the people of Cuba have resisted and they “deserve the prize of dignity, and that island should be considered as the new Numantia for its example of resistance, and I think that for the same reason should be declared a world heritage site.”

So far, so good; all this was standard leftist rhetoric pleasing to the ears of most Latin American politicians and intellectuals. This would have been a good time to finish the speech with warm applauses from the audience. But AMLO can be full of surprises. After the traditional bashing of the U.S. and the adulation for Cuba, AMLO suddenly pivoted from confrontation to conciliation.

Actually, AMLO claimed, we now live in a new world where the past is not relevant.

Times have changed, AMLO said. The policies of the past benefit no one. “Unbeatable conditions” currently exist for a new relationship based on respect and common purpose. According to AMLO, the “rise of China has strengthened the opinion in the United States that we should be seen as allies and not as distant neighbors.” Nearly 30 years of integration with the United States through NAFTA make the countries “mutually indispensable and well positioned to recover what was lost with respect to production and trade with China, than to continue weakening as a region and to have in the Pacific a scene plagued with warlike tensions; To put it in other words, we want the United States to be strong economically and not just militarily. Achieving this balance and not the hegemony of any country, is the most responsible and most convenient way to maintain peace for the good of future generations and humanity.”

According to AMLO, Mexico’s best way forward is to participate in a vibrant and successful North American economy. “Besides, I don’t see any other way out; We cannot close our economies or bet on the application of tariffs to exporting countries of the world, much less should we declare a trade war on anyone. I think the best thing is to be efficient, creative, strengthen our regional market and compete with any country or region in the world.”

Conclusion

What should we make of AMLO’s remarkable speech?

First, It is obviously a sign that the initial contacts with the Biden Administration have been constructive. Given AMLO’s strange “love affair” with Trump and initial coolness towards Biden, concerns of a falling out were real but it now appears that they were unfounded. AMLO’s positioning towards the United States is grounded in a pragmatic understanding of interdependence.

Second, in this speech AMLO expresses a sound understanding of Mexico’s strategic opportunities in the context of the decoupling of the Chinese and American economies. This should provide some comfort to investors on both sides of the border.

Constructive relations between the U.S. and Mexico and a understanding that the two countries have a common purpose is certainly good news. Nevertheless, there remain many contentious issues to resolve.

From the American point of view, AMLO’s view on state domination of key sectors is not compatible with the updated USCMA trade agreement. Recent violation of contracts with American companies in the energy sector are not acceptable to the U.S.

Nevertheless, the conciliatory and optimistic tone of the speech is important. There are few countries in emerging markets today that have brighter prospects for their stock market than Mexico which has low valuations, an undervalued currency and strong fiscal position. Mexico could potentially attract huge investments for the reshoring of U.S. manufacturing supply chains which could boost GDP growth from the current low levels. Until today, AMLO’s hardline anti-business stance has been the major impediment to investing in Mexico. A more pragmatic , conciliatory and forward thinking AMLO could possibly be a catalyst for better days ahead.

Update on Emerging Market Valuations and Expected Market Returns

Emerging market stocks ended the second quarter badly underperforming the S&P500 and the MSCI All Country World Index (ACWI) year-to-date, as well as for the past one, three, five and ten years. There had been some hope during the first quarter that rising inflation and interest rates would squash long duration assets like U.S. tech and give a chance for value stocks and emerging markets to outperform. However, this was short-lived. By the end of the second quarter, interest rates were collapsing, U.S. tech stocks were leading the way again and American exceptionalism was reaffirmed by the U.S. indexes hitting record levels at near-record valuations.

The second quarter and the year so far, therefore, brought more woes for emerging markets. Momentum has been the primary force for markets, driving the expensive stocks higher and the cheap stocks lower. We can see this clearly in the charts below which show (1) country returns YTD for EM and (2) expected returns based on relative cyclically adjusted price earnings (CAPE) ratios.

With the exception of Brazil and South Africa, two countries benefitting from positive terms of trade shocks from rising commodity prices, the countries with the highest expected future returns (Turkey, Philippines, Peru, Colombia. Indonesia, Chile and Malaysia) are also the ones with the lowest returns for the period. On the other hand, the expensive countries with low expected future returns (India, Korea, Russia, Mexico, Taiwan) continue to outperform. Of course, the United States, the most expensive of any market around the world, provided stellar returns of 14.9% during the first half of the year.

Unfortunately, the countries with very inexpensive markets relative to their history are not helping themselves. Sadly, none of the “cheap” markets currently provide a positive narrative for investors. In addition to the pandemic which continues to wreak havoc across EM, many countries also face deteriorating political and economic fundamentals which would justify lower earnings multiples than a relative cape ratio methodology implies. We could argue that the growth prospects for Brazil, Chile, Colombia, Peru and South Africa have deteriorated enough over the past decade to justify lower CAPE multiples. In many cases, historical CAPE multiples may have been distorted by the stratospheric-level valuations reached during the 2007-2012 EM bubble. It may be that some of these markets need to trade at much lower multiples to become attractive investments, say more in line with Turkey today (4.4 CAPE). Arguably, investors should be very cautious at deploying capital until a positive narrative can be developed in these countries.

This leaves us with very few markets to focus on. In Asia, which is where almost all the growth in GDP and consumption will occur over the next decade, Indonesia and Malaysia have good growth prospects and political stability. Their CAPE ratios are cheap in both relative and absolute terms and promise good future returns. Moreover, we can see in the following chart that they both have competitive currencies and good economic fundamentals. The Philippines also appear attractive, given low valuations and a good growth profile, but have an overvalued currency and weaker fundamentals. In Latin America, Mexico also has a nice combination of an attractive CAPE valuation, competitive currency and good economic fundamentals.

The best opportunity in EM stocks today is in Turkey which has the compelling combination of very low CAPE valuation and undervalued currency. The patient investor would be well advised to build positions ahead of an eventual change in government or economic policy.

The Lure of Complexity Drains Pension Schemes Around the World

The debate over whether to invest “passively” through index funds or “actively” through professionally managed funds has largely been resolved in favor of the passive camp. Decades of empirical data have made the case for passive and the result has been the persistent growth of index investing for both individual and institutional investors. Yet, in defiance of this trend, the financial industry continues to create and sell trillions of dollars in increasingly complex products with much higher fees. These so-called “alternative” financial products have made huge fortunes for managers of hedge funds, private equity funds, and other exotic products. Unfortunately, by and large, they fail to provide value for the investors that have been lured into believing that complexity brings higher returns.

David Swensen of the Yale Endowment was a pioneer in the use of alternative assets. The good performance of this strategy in the 1990s and several books by Swensen lauding its merits attracted many imitators to the “Yale Model.” At the same time, the rise of low-cost index funds on traditional equity products drove the wily Wall Street marketing machine to promote new products with high fees. As a result, from 1997 to 2018 hedge fund assets under management grew from $118 billion to $3.5 trillion. Over the same period, the number of active private equity firms grew more than tenfold, from fewer than 1,000 to roughly 10,000. In the case of educational endowments like Swensen’s Yale, the average exposure to alternatives has risen from 12% in 1990 to 34% in 2002 and to around 60% of total assets today.

Unfortunately, Swensen was not able to sustain the high returns achieved in the 1990s, the “Golden Age of alternative investing.” Ironically, the popularity of the Yale model may have been its undoing. Over the 2010-2019 period Yale returned 11.1% annually compared to S&P 500 returns of 14.7% and returns of 11.4% for a traditional 70/30 stock/bond mix. This is before the operating expenses of the Yale endowment which total 0.38% annually. Nevertheless, Yale continued to be one of the best performing university endowments over this period.

The most recent study of the performance of public pension funds and university endowments, “HOW TO IMPROVE INSTITUTIONAL FUND PERFORMANCE,” by Richard M. Ennis (link) describes how the Yale model has destroyed value for institutional investors. Desperate for higher returns in a world of overvalued assets and low prospective returns, these funds have allocated over a trillion dollar s to alternatives and have nothing to show for it. As a group, they would have been much better off buying a few Vanguard index funds.

Ennis’s study of 46 public pension funds highlights the following:

Only two of the 46 endowments outperformed with statistical significance.
A composite of the funds surveyed underperformed by 155 bps per year for the 12 years ending June 30,2020, and the composite underperformed in 11 of the twelve years.
Alternatives, which represented 30% of assets, provided no diversification benefits, acting equity-like in their risk profile, with added leverage.
Poor performance is not tied to size of the fund. In fact, most underperformance was attributed to exposure to alternatives.

Ennis’s survey of university endowments identified even poorer performance than for public pension funds. This is remarkable given that the staffs of endowments are considered to be more skilled and are paid multiples more than the public servants that typically staff pension funds.

Here are the key findings from Ennis’s research:

Endowments with assets greater than $1 billion underperformed by 1.87% per year over the period and trailed the benchmark in 12 out of 12 years.
Alternatives represented 60% of the asset allocation of endowments, providing no diversification benefit but dramatically increasing costs. Ellis estimates that the fees paid to managers by these endowments run at about 1.8% of assets per year and explain almost all the underperformance.
The performance of endowments actually is overstated, since they do not include their own operational expenses in their performance numbers. In the case of Yale these expenses were 0.38% of assets under management.

Ellis estimates that pension funds paid around $70 billion in fees to Wall Street in 2020 all of which they could have saved by investing in low-cost index products. Endowment funds paid $11.5 billion in fees plus about $2.5 billion in expenses (salaries, rents), all of which they could have avoided by investing in index funds.

Ellis’s data on endowments comes primarily from the annual NACUBO-TIAA (link) study of endowments which reports on the sector’s overall results. Using this same source Fiduciary Wealth Partners, a firm that provides investment advice to high net-worth clients, has tracked the returns provided by the top quartile performing endowment funds for the past twenty years and compared these to returns achievable through low-cost index funds. FWP confirms Ellis’s finding that even the elite of the endowments have destroyed value. The two charts below show (1) the portfolio allocation of low cost index funds used by FWP and (2) the 10-year rolling returns of this model portfolio including all fees compared to the composite returns of the top quartile endowments. The 70/30 index portfolio has outperformed in every 10-year rolling period and by a considerable margin over the time frame considered. This is before considering the internal operating expenses of the endowments.

Implications for public pension funds around the world

The case of U.S. pensions and endowments should provide a good example for the world. The lure of complexity and the belief that sophisticated high-fee managers can add value after fees is as prevalent in public pension schemes in Latin America and sovereign funds around the world as it is in the U.S.

Ellis describes the situation of the public pension funds of the City of Los Angeles as a microcosm of what ails public pension systems around the world. Taxpayers of the city back six different public pension funds representing different groups (teachers, fire-police, city employees, water-power, county employees and state employees.) All these funds replicate a similar investment cost-base and follow similar “diversified” investment processes. The final result is an immense index-like fund with an expense of 1.1% per year. This cost, in the end is born by the taxpayer.

The obvious path for these public pension funds would be to merge and simplify their investment processes through low-cost indexing approaches. However, this is difficult to do because of the resistance from the agents currently involved in the process: the managers, investment professionals, trustees and outside advisors that have a stake in the current system.

This situation of Los Angeles is repeated across the world.

An extreme example this is the Chilean AFP system of privately managed pensions. Designed by Chile’s “Chicago Boys” free market ideologues in the 1980s, the AFP model was based on the conviction that private competition would bring about a fruitful combination of minimal costs and maximum returns, to the benefit of Chilean pensioners. However, after 35 years of the AFP model we can see a situation similar to the one of the the City of Los Angeles. The system has high costs which hurt returns for pensioners; seven AFP firms compete for customers, replicating high administrative and marketing costs, for a relatively small pool of assets of $200 billion. The primary beneficiaries of the AFP system, as in Los Angeles, are the agents (owners of the AFPs, managers, administrators, regulators). Much better results could be achieved by a small committee deciding on a long term allocation strategy and allocating the system’s funds to index products.

In fact, there are a few examples of funds that have followed the path recommended by Ellis.

One example is Nevada’s $35 billion Public Employees Retirement System (link). Unlike Los Angeles and Chile with their teams of managers, administrators, marketers and advisers, the CIO, Steve Edmunson, manages the fund by himself. Following Warren Buffet’s advice, Edmunson shuns fees and practices inactivity. Nevada’s funds are allocated to ETFs and a few trades a year suffice to keep them aligned with the long-term strategy. With an investment staff of one person, Nevada’s costs are 5 basis points (0.05%) compared to the 1.5% average estimated by Ennis for U.S. public pension funds.