Investing in emerging markets poses significant challenges for asset managers and owners alike, with one of the largest emerging markets in the world considered to be uninvestable in its own right, and market benchmarks not accurately reflecting the mix or development of underlying economies.
TelstraSuper head of equities Dominique D’Avrincourt told the Investment Magazine Equities Summit in Sydney last month that APRA-regulated funds find it difficult to invest on a standalone basis in markets like China because it is hard to accurately price risk. The funds that apply an ESG lens to their portfolios also find it difficult to invest there, given corporate governance issues.
“There is no EM or global manager, that I’ve met anyway, that will go overweight China if they have a very strong governance lens,“ D’Avrincourt said.
“The reason I have China is not necessarily because I like the investment that it provides, it’s because I have to manage my tracking error versus the benchmark that I’ve been given.”
“So I completely agree… that the benchmark is problematic. If we had an absolute return objective, we probably wouldn’t have China because, again, I think it’s uninvestable or at the very least ‘not portfolio manageable’, and I would have India instead.”
“I just do not think that we can accurately forecast or price the risk of investing in China, and the risk of the permanent loss of capital is very, very high.”
Daniel Grana, emerging markets equity portfolio manager at Janus Henderson Investors, said investors who lose sight of what drives the Chinese market put themselves at considerable risk.
“China is not a rule-of-law country, it’s a rule-of-party [country],” he said.
“Just to be clear, it’s this is not just a China thing, it’s just more obvious in China. But all emerging markets, when you go against the government’s wishes, the government’s policies, you run a risk. It is just more pronounced in China.
“And so, in addition to corporate governance – worrying about what the majority shareholder does to minority shareholders – if you don’t incorporate some sense of political governance, when you invest in China, then you have no business investing in China – full stop.”
Oaktree Capital’s managing director and portfolio manager Frank Carroll agreed that investors need to stay on the right side of government but said investors who do that can find some really interesting opportunities.
“The Chinese government wants bigger SOEs [state-owned enterprises],” he said. “And they also need some capital return.”
“And so what have we seen China doing? Closing coal mines, closing, polluting steel mills, and really consolidating that into bigger state champions, bigger state champions that have managements that have been tested.”
“There’s a lot to invest in on the value side, a bunch of stocks that no one has cared about for a long time, because previously, generally speaking, it was only seven to 10 big growth names. And I agree, it’s nearly impossible to create tracking error in an emerging markets fund given the index concentration. It’s remarkable: you can have 10 stocks, and you still don’t have tracking error.”
Issues with benchmarks
Grana said investors’ issues with investing in emerging markets are compounded by the cowardice of the company that constructs the emerging markets index.
“They are slow to recognise change,” Grana said. “They under-index the future. So MercadoLibre, which is Latin America’s Amazon is not in the benchmark. They are afraid to upgrade Taiwan and Korea from emerging to developed. Why? Because they’re cowards.”
“They’re afraid of making a political statement that Taiwan is not part of China. They’re afraid of the moment they upgrade Korea, that the bombs will land. The last country to be upgraded from emerging markets was Israel about 15 or 16 years ago.
“And they keep adding new ones. So Saudi Arabia, Qatar, UAE were added about three, four years ago; Vietnam is likely to be added in a three- to five-year timeframe. This index is very dynamic, not because of the index provider.
They do a very poor job of capturing the opportunity set. And I would strongly suggest that when you’re looking for an EM manager, you look for someone who broadens the lens beyond what simply is in the benchmark.”
Fear of missing out
Oaktree’s Carroll said the biggest risk posed by emerging markets it to not be invested in them.
“It was much more risky nine months ago, when the world was perfect, to be in the markets than it is today,” he said.
“I’m not saying you go all in, but this is the time to be doing the work to get back in if you’re not in.”
TelstraSuper’s D’Avrincourt said it’s currently too risky to invest in emerging markets if you’re a short-term investor. “But if you’re a long-term investor, I think it’s probably a good time.” she said.
“In the short term, I can’t say where it’s going to go in the next six to 12 months. I think emerging markets have been the way to go for the last 10 years. But going forward, there may be different ways and more innovative ways of spending the risk budget by being more regional-focused or country-focused.”