The case for active management

Global Emerging Markets

The case for active management

Emerging markets look well placed to outperform developed markets as profitability recovers. That said, the growth outlook across these markets is asymmetric in nature. Demographic and political trends are also widening across the asset class. With that in mind, investors need to think carefully about how best to access the long-term growth story these markets can offer. In particular, should investors opt for a passive or active approach?


There are five important factors to consider when making that decision:

1.    informational and structural inefficiencies are higher in emerging markets than their developed counterparts;

2.    similarly, size isn’t necessarily synonymous with quality;

3.    concentration is a growing problem;

4.    secular changes and structural tailwinds can be more pronounced in some areas than others;

5.    and, last, but not least, governance and sustainability analysis is critical in emerging markets.

This paper sets out why taking an active approach is the most effective way of allocating in the asset class.

 

Exploiting market inefficiency and hetrogenity

Compared with several developed markets, the US in particular, emerging markets still exhibit a relatively significant amount of informational and structural inefficiency, with lower levels of research coverage and forecasting data. It is in this environment that an active manager can add significant value, with greater scope for identifying mispriced opportunities through proprietary research and fundamental company analysis.

Heterogeneity is another defining characteristic of the asset class that favours active management. Compared with many developed markets there are large disparities, not only in economic growth patterns, demography, and political dynamics, but also more granular, country and company-specific areas of difference.

From a stockpicking perspective, this inevitably creates a greater differentiation between winners and losers. It is also our belief that emerging markets are not tending towards the homogenous monolithic structure of many developed markets. If anything, we believe that emerging markets are becoming even more heterogeneous in their make up.

Economic fortunes continue to appear starkly diverged between emerging market countries, even among the much-talked-about BRICs grouping (Brazil, Russia, India and China). China’s economy, for instance, continues to decelerate, working to avoid a ‘hard landing’ and to deal with the need for debt restructuring. On the other hand, economic activity in India remains buoyant as the country embraces structural reforms and benefits from lower commodity prices.

These asymmetrical growth outlooks, combined with widening differences in demographic and political trends, across the asset class increasingly suit an investment approach which can effectively discriminate at a country and company level.

 

Freedom of choice

Active management also offers a greater degree of investment discretion, another significant advantage in emerging markets. The majority of passive strategies, because they are market-cap weighted, can have significant biases to the movement of large companies or particular countries within an index.

In emerging markets this point is particularly salient. At the country level, concentration has been increasing in recent years. The top five countries in the MSCI Emerging Markets index, for example, accounted for 71.7% of the index at the end of July 2017 - nearly 9% more than they did a decade before[1]. The fortunes of the index are therefore increasingly tied to a smaller number of economies, particularly China, which now represents over a quarter of the index.

At the corporate level, many of the larger-weighted companies are state-owned enterprises (SOEs), which are often not run in the interests of minority shareholders and tend to exhibit poor levels of corporate governance.

By allowing for greater discretion, an active approach can avoid this kind of unwanted exposure.

Furthermore, following a benchmark can potentially be highly constrictive. The emerging market investment universe represents a huge opportunity set, a large portion of which falls outside of the index weighting.

Active management provides the freedom of choice to invest across a broader geographic spread, but also to identify companies with high and sustainable returns (inappropriately priced to fade) or those that can improve their ability to generate returns on capital. Emerging markets present some compelling opportunities in this regard as the power of change and long-term value creation in many companies is often significantly underestimated and thus undervalued.

 

Accessing structural tailwinds

A discerning investment approach is not only important to avoid unwanted or excessive exposure to various parts of the universe. It is also essential to interpreting some of the compelling growth drivers within the asset class: favourable demographics; increasing urbanisation; structural reform; infrastructure programmes; and a burgeoning and increasingly politically assertive middle class – to mention but a few.

By investing actively at the company level, it is possible to benefit from secular change and structural tailwinds much earlier and more profitably than it is by tracking an index. The ‘value add’ in this sense is the active manager’s ability to infer secular change with much greater multi-disciplinary rigour than even the most sophisticated rules-based approach.

Take the growth potential of financial technology (Fintech) for example. The technological advances in financial services that are reshaping and creating new value in the industry are perhaps most pronounced in emerging markets, where the penetration of banking and insurance services is typically lower. Alternative banking solutions and the companies that provide them can have a hugely disruptive effect on existing industry structures through areas such as microfinance and payments-and-transfers systems. While much of the opportunity in this particular space is in unlisted firms, there is considerable read-across to established industry players. In this sense, active managers can be on the front foot in terms of identifying those companies truly taking advantage of this kind of innovation.

And as China rebalances from an investment-driven to a consumption-based economy, the structural drivers within emerging markets will continue to shift. Again, active management allows for more considered and nuanced long-term plays towards those areas of increasing significance in China: away from ‘old economy’ businesses which have been historically well represented in index configurations to ‘new economy’ companies not yet fully prominent within benchmarks.

 

Reaping the benefits of governance and sustainability analysis

Given the potential for higher levels of both risk and return present in emerging market investment, governance and sustainability analysis is critical. The institutions and regulatory frameworks protecting investors in more developed markets may often not be as evolved in many emerging market economies. In addition, while levels of corporate governance in many emerging market companies are improving, there is still a long way to go before they match developed market standards.

While there has been an increase in the number of many passive strategies that have adopted ESG ‘screens’, these suffer from a number of fundamental weaknesses. Critical among these is the fact that a rules-based strategy is wholly dependent on the quality and consistency of the data used to construct a portfolio. This may be perceived by some to be less of a problem in developed markets, but is a serious stumbling block in the emerging world, where disclosure of ESG information remains patchy.

Another significant problem is that these types of screens are backward-looking and can be slow to react to changing circumstances, as re-weightings tend to happen on an infrequent basis. They are also susceptible to biases, for instance by focusing on too many ESG indicators – which tends to favour large-cap companies with significant reporting resources and penalises smaller and medium-cap ones with less extensive disclosure. Last, but not least, while a rule-based approach sends a signal as to best practice from capital providers to companies, it is arguably a poor substitute for the active ownership that a discretionary manager can engage more fully in.

By contrast, a forward-looking, pragmatic approach that actively incorporates an assessment of a company’s governance and sustainability credentials enhances fundamental research, and can help identify those business models that are most likely to sustain high returns and resist competitive pressures. This, however, involves dynamic analysis and ongoing company engagement; an approach only possible with active management.

 

Conclusion

Active investment management has some distinct advantages in an emerging market context. The changing nature of the asset class, where growing heterogeneity is being met with greater concentration in indices, means that a discretionary approach can offer the best opportunities to access many of the structural growth drivers in these markets. It can also help avoid unwanted exposures to excessive market-cap and regional biases.

The lack of information and market inefficiency in emerging markets compared to more developed markets is an ongoing reason for an active approach to long-term investment in the asset class. This is evident when considering the vital importance of ESG considerations in investment decisions. While there are many passive strategies that adopt rules-based ESG approaches, these lack the pragmatic engagement and informational benefits that active management can bring.

Ultimately, as the unique characteristics of emerging markets become more pronounced, it is imperative that investors consider a stock- driven approach based on thorough fundamental analysis to limit exposure to capital loss and to generate sustainable returns into the long term.

 

[1] MSCI Emerging Markets regional weightings 31 July 2017 and 31 July 2007

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IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.