Emerging markets are not the place for passive investing

Active managers that deploy robust ESG policies should find quality stocks rewarded

Emerging-Market-India-Asia-700x450.jpgThe sheer diversity of the countries that make up the emerging market complex shows establishing an investment process to incorporate the information required to manage a fund is no simple undertaking.

What has Brazil got to do with Taiwan? Or South Africa with the United Arab Emirates? Gaining sufficient knowledge about the different emerging economies requires robust analytical resources and effective screening tools.

Given the commitment required to do this, it is no surprise the Investment Association Global Emerging Markets sector is dominated by franchises that have been active in such investing for many years and have therefore been the dominant asset gatherers.

For UK investors, Hugh Young of Aberdeen Asset Management (now Aberdeen Standard Investments), Angus Tulloch (now retired) of Stewart Investors and the ever-ebullient Mark Mobius of Franklin Templeton are instantly recognised for their long-standing commitment to emerging market equities.

It is no coincidence the likes of Aberdeen and Stewart Investors also have successful Asian equity franchises. The largest countries in the broad emerging market index are China, South Korea and Taiwan, with the emerging Asia component totalling a whopping 73 per cent.

By contrast, the emerging Latin America component is around 13 per cent, Europe 6 per cent and Africa 7 per cent, while the Middle East is minimal. So strong knowledge of the Asian equity markets is critical.

The other notable feature of long-standing franchises in this area is their dedication to environmental, social and governance policies. They are becoming increasingly integrated into processes for managers in all markets but such considerations have been at the heart of emerging market investment approaches for many years by necessity.

As in all areas of investment, passive vehicles have grown in popularity for emerging market equity exposure. Indeed, the Vanguard Emerging Markets Stock Index fund is now £1.3bn in size and one of the largest in the sector.

Without delving into the well-rehearsed arguments for passives, we certainly agree there can be good reasons to opt for index products in some markets. However, in terms of emerging markets, we hold a different view.

The use of passives in developed markets that benefit from a rule of law most of us understand can be a valid approach. But how do people feel about investing in developing markets during more troubled political and economic times? And how would they feel if they had exposure to a company that mistreats employees or has a poor record of environment stewardship?

These concerns are not limited to emerging markets, but we can argue they warrant a more selective approach. Those concerned with such issues may prefer to invest with managers who deploy robust ESG policies. The ‘quid pro quo’ is that this approach can deliver a different risk and return journey compared to the index and, therefore, relative risk can be elevated.

Such funds typically struggle to keep up with momentum-fuelled, upward-moving markets driven by lower quality and/or cyclical companies, but tend to outperform when fundamentals are in charge and/or sentiment is less bullish.

This is not always the case, as particular themes and dynamics can come into play but, clearly, the hope is that better quality stocks with stronger governance are rewarded over the long term. Even if this is not the case, investors can draw comfort from the fact their capital is being allocated with care and attention.

Investment styles

The majority of emerging market managers operate a quality/growth investment approach. This links to the points above and, when you think about it, how much appetite do investors really have for recovery and/or value approaches in these markets? Such styles can deliver powerful bouts of performance but can be nerve-wracking when held throughout the cycle.

In an environment of lacklustre global economic growth and rock-bottom interest rates, quality/growth styles and income-biased approaches have been favoured.

Last year, we saw signs of life from value-biased funds as the global economy found a firmer footing, commodity prices recovered and more palatable valuations attracted investors. However, growth styles have returned to the fore again in recent months as economic indicators show signs of losing momentum, inflation remains subdued and China enforces a leverage-reduction exercise.

Tensions between the US and North Korea have also played their part in fostering greater caution from investors; hence, capital is moving away from emerging markets. International flows remain a crucial factor in the fortunes of emerging markets.

Fund picks

Aberdeen Emerging Markets Equity and Stewart Investors Global Emerging Market Leaders (featured in the IA Specialist sector) fall into the quality/growth camp and are managed with a strong commitment to ESG policies.

Investec Emerging Markets Equity is managed using the firm’s 4Factor framework for identifying high quality, attractively valued companies that are receiving investor attention. The objective investment approach means there is no pre-determined style bias and, while not core in nature, it is one of the more balanced funds in the sector by dint of the disciplined process and its risk controls.

Lazard Emerging Markets and M&G Global Emerging Markets are differentiated from others in the sector by their more prevalent value credentials. Both funds are strongly driven by their assessments of company fundamentals and, typically, performance flourishes during a more positive backdrop for the asset class.

Gill Hutchison is research director at The Adviser Centre

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