Understanding emerging market equity
While the emerging markets (EMs) theme seems to come in and out of fashion every few years, the thesis for taking advantage of the long-term, yet volatile growth that these markets are forecast to deliver remains robust. Nevertheless, many investors maintain a structural underweight to this area both specifi cally in their equity allocation and asset allocations, more broadly. Although EMs represent almost 50% of the world s GDP, their share of world equity market indices is only about 11%, and they also tend to represent a substantially smaller portion of most institutional equity portfolios. For example, BlackRock indicated recently that the average US investor only has a 5% allocation to EMs. Anecdotally, we believe this low allocation may be fairly representative of the wider institutional investor base. We believe that investors should be considering their current allocations to EMs. One of the fi rst things for investors to understand when they consider the EMs is the contrast between the breadth of the markets and the concentration of the MSCI emerging market (MSCI EM) index. Developed market investors often think of EMs as a somewhat homogeneous group, characterised (simplistically) by high growth and higher volatility, but lower governance standards. In reality, the EMs represent diverse countries, spread across fi ve continents with different cultures, languages, political systems, regulatory regimes, demographic profi les and stages of development. When frontier markets (markets that are not classifi ed as developed or emerging) are included, this universe becomes more diverse. While there are many thousands of companies listed in EMs, for reasons such as liquidity, the MSCI EM index contains only about 800 stocks. The China A-share market is also not represented in the index, as it is not yet a freely traded market. The MSCI EM index has some notable areas of concentration in terms of stock, sector and country. For example, the largest four countries in the MSCI EM index represent about 56% of the index, despite the index containing 21 countries. Furthermore, the index is typically dominated by a relatively small number of very large companies. Figures 01 and 03 illustrate the concentration in certain parts of the market. As the charts show, the energy, financial and telecommunication sectors comprise a small number of large companies that are, perhaps, over-represented in the index. Conversely, there are many industrial, consumer, and healthcare companies that seem under-represented. Figure 01. Sector concentration in EMs 0 20 40 Utilities Telecommunication services Information technology Financials Healthcare Consumer staples Consumer discretionary Industrials Materials Energy % of companies in universe MSCI EM weight Understanding emerging market equity 3
State-owned enterprises (SOEs) Many companies in emerging markets have large controlling shareholders. These may be families, entrepreneurs or state-controlled entities. Companies that are partly owned by these state entities are called state-owned enterprises. Many of the large energy, financial and telecommunication companies that dominate the index tend to be SOEs. Figure 02 shows the dominance of SOEs in EMs compared to developed markets. Investors question whether SOEs are always run for the benefit of the minority shareholder or whether they are the most efficient allocators of capital. We can also see from Figure 03 that similar levels of concentration exist at the country level. Investing in EMs Many institutional investors seek to invest in EMs to access the expected growth in these countries, particularly through increasing consumption. However, as we have seen, EM indices may give investors higher concentration than they might expect in companies that are not purely exposed to these drivers of EM growth. For example, a large portion of the index comprises energy/commodity companies and exporters, which may be more reliant on global growth (rather than EM growth) and SOEs which may not deliver the desired level of shareholder return. Accessing EM equity The usual ways of accessing equity markets apply similarly in EMs. There are investment options for traditional bulk beta (passive market capitalisation approaches), smart beta, and alpha (active managers). However, there are important considerations for implementation which are specific to EMs. Passive market capitalisation approach Market capitalisation-weighted passive exposure is now reasonably cheap and offers a high standard of index tracking (although perhaps not as close as in developed markets). Institutional passive product fees have fallen in price, with a standard fee for a US$50 million mandate now typically below 0.15% per annum. These products offer broad exposure to EMs and are, by their nature, not capacity-constrained. However, we remain concerned about passive exchange-traded funds (ETFs) for emerging market equities, as these tend to have high fees (a leading EM ETF has a total expense ratio of 0.67% per annum) and have displayed fairly high tracking errors over time. Figure 02. Proportion of SOEs in market indices 30% 25% 20% 15% 10% 5% 0% Morocco Hungary Czech Rep Egypt Peru Philippines Colombia Poland Turkey Chile Thailand Indonesia Malaysia Mexico Russia India South Africa Taiwan Brazil Korea China Emerging markets Developed markets Share of state companies in market capitalisation Figure 03. Number of companies and index weight by country 0 10 20 30 40 % of companies by listing (excluding A-shares) % of companies in universe MSCI EM weight 4 towerswatson.com
Passive market capitalisation products represent suitable implementation options for many clients for reasons such as simplicity, low cost and broad exposure. However, for reasons set out in this article, Towers Watson believes that other smart beta or active management approaches may, in theory, be preferable. Smart beta The main objective of smart beta is to capture a particular risk premium for a low cost. These strategies are expected to provide more superior investment efficiency than bulk beta (passive market capitalisation). Please see Towers Watson s article Using smart beta in equities 1 for further information on this topic. These smart betas include value-weighted strategies, low volatility strategies and diversification-based strategies. All require careful consideration and have implications for portfolio implementation. Fees for these strategies are more expensive than their developed market equivalents but, at around 0.30%, represent reasonable value in EMs. Active management Active management is, in theory, very attractive in EMs. It is often argued that EM equity is a less efficient asset class, in part due to the issues discussed above, but also because sell-side analyst coverage has typically been lower in EMs (although this is increasingly less the case). Active managers are potentially better able to assess the quality of company governance and the actions of management, which can be very important in EMs. Active managers may also have freedom to invest in EM stocks that are listed on developed market stock exchanges. These can include multinational companies with high EM presence/exposure. But more importantly, genuine EM businesses that have, for various reasons, chosen to list elsewhere. Active managers are therefore able to select those companies that are most exposed to key EM drivers, which may not be some of the large EM index stocks. However, there are also some structural challenges facing active management in EMs. 2. Large asset bases: Large teams typically require larger asset bases to support them. Additionally, they are often found in large businesses rather than specialist boutiques. 3. Capacity problems and reduced alignment: Large firms with weaker alignments of interest may be more motivated to grow their asset base. Indeed, we have observed that many of the leading EM investment managers are now closed to new business or have prohibitively large asset bases. Figure 04 demonstrates the reduction in opportunity set experienced when managers grow their assets under management in excess of US$20 to $30 billion. There are many managers that are of this scale. 4. High fees: There is a relatively limited universe of skilled and experienced EM managers compared to US or global equities. As more assets flow into EMs this limited supply has greater demand. As such, standard fees are high. Screening the evestment Alliance database, 2 global EM equity managers suggest an average annual fee for a US$50 million account of 0.92%. This compares to 0.73% for the global equity universe. It is not obvious whether this higher fee is justified by higher (expected) alpha. 5. Transaction costs tend to be higher: This is another hurdle that active managers need to overcome to deliver added value net-of-fees to investors. Figure 04. Percentage of universe stocks that are investable Based on 1% position at various assets under management, given the desire to hold <5% of a company s market capitalisation 100% 90% 80% 70% 60% 50% 40% 1. Large teams: Diverse markets, cultures and languages often lead managers to hire more staff to gain broader local knowledge. Bigger teams can typically present more challenges to communication and culture and can potentially become bureaucratic. 30% 20% 10% 0% 0 100 1,000 2,000 5,000 10,000 20,000 30,000 Assets under management (US$ millions) Frontier markets EM small capitalisation EM Understanding emerging market equity 5
Types of active managers Active EM managers tend to fall into two broad categories. The first are those that provide broad market coverage across most sectors and regions in the market. These products tend to be larger and more scalable, and often come with modest tracking errors. Skilled managers can be found in this category although few are expected to deliver attractive returns net of fees, given the higher fees for the level of risk and capacity issues. The second category comprises managers that are less benchmark-sensitive and focus more on maximising long-term absolute returns or accessing a particular theme (such as domestic EM growth). These types of managers will often eschew, for example, global commodity companies, large index constituents or perhaps SOEs. Their portfolios can therefore often look very different to market indices and have high tracking errors, and perhaps biases to smaller capitalisation stocks or certain sectors (for example consumer goods) relative to the EM index. How Towers Watson can help investors Towers Watson s Asia and emerging market research teams have conducted extensive research into these markets and the investment managers that operate in them. We believe that the emerging markets offer exciting long-term investment opportunities, but implementing investments in this region is diffi cult. More detailed understanding and awareness of the key issues are required. Despite the challenges, we have identifi ed a select group of active managers that we consider to have attractive value propositions net of fees. These managers, together with passive and smart beta offerings, may provide investors with various ways to exploit the attractive structural opportunity that we believe emerging market equities present. References 1 Using smart beta in equities. Towers Watson Limited, 2013. 2 As at Q2 2013. As well as global EM managers, there are various regional managers and frontier market managers. Towers Watson has research coverage in this area, but investors rarely have the size of allocation or governance to construct portfolios containing many regional managers. Frontier markets In a similar manner to emerging markets, frontier markets offer a broad and diverse opportunity set that we believe can benefi t from long-term growth drivers. However, lack of liquidity, relatively poor governance standards and earlier stages of economic development make these markets unattractive for many investors. We believe that signifi cant investor skill is required when investing in these markets due to the above constraints and so avoid passive allocations in these markets. We believe that allowing skilled emerging market managers the ability to invest in frontier markets can give further potential for added value in the long term. Further information For further information, please contact your Towers Watson consultant, or Stuart Gray +44 1737 274410 stuart.gray@towerswatson.com 6 towerswatson.com
Understanding emerging market equity 7
About Towers Watson Towers Watson is a leading global professional services company that helps organisations improve performance through effective people, risk and financial management. With more than 14,000 associates around the world, we offer consulting, technology and solutions in the areas of benefits, talent management, rewards, and risk and capital management. Towers Watson 21 Tothill Street Westminster London SW1H 9LL This document was prepared for general information purposes only and should not be considered a substitute for specific professional advice. In particular, its contents are not intended by Towers Watson to be construed as the provision of investment, legal, accounting, tax or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. As such, this document should not be relied upon for investment or other financial decisions and no such decisions should be taken on the basis of its contents without seeking specific advice. This document is based on information available to Towers Watson at the date of issue, and takes no account of subsequent developments after that date. In addition, past performance is not indicative of future results. In producing this document Towers Watson has relied upon the accuracy and completeness of certain data and information obtained from third parties. This document may not be reproduced or distributed to any other party, whether in whole or in part, without Towers Watson s prior written permission, except as may be required by law. In the absence of its express written permission to the contrary, Towers Watson and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on the contents of this document including any opinions expressed herein. To unsubscribe, email eu.unsubscribe@towerswatson.com with the publication name as the subject and include your name, title and company address. Copyright 2014 Towers Watson. All rights reserved. TW-EU-2014-36399. April 2014. towerswatson.com