Emerging market funds seek escape from traditional indexes
LONDON: Emerging market fund managers are seeking to escape from the straitjacket of traditional benchmark indexes in favor of a more flexible approach to capture the diverging performances of different countries and sectors. The dilemma for such investors is illustrated by MSCI’s widely used emerging equity benchmark. So far this year, this index .MSCIEF is down more than 12 percent, mainly due to losses in big markets such as Brazil and China. Minor player Hungary, however, has gained some 30 percent .BUX.
Similarly, in the debt market, Russian rouble bonds have returned 20 percent this year versus double-digit losses on the underlying emerging debt index which is driven by Brazil and South Africa. Hence, asset managers are behind tempted towards treating each country on its own merits, moving away from traditional indexes or even dumping them altogether.
Columbia Threadneedle, for example, increasingly runs bond portfolios on a global ‘go anywhere’ basis, as boundaries between emerging and emerged economies have blurred.
“So it’s not: ‘I want this in emerging markets’ – we just try to identify value where we find it,” its chief investment officer, Mark Burgess, told the recent Reuters Global Investment Outlook Summit. Even under the emerging markets umbrella, at least 14 multi-asset and ‘blended’ EM funds have been launched in Europe since 2013 in response to calls for more flexibility, according to Lipper, a Thomson Reuters information service.
These funds allow managers to invest across emerging equities, local and hard currency debt, and corporate debt to find the best returns. So shares in a Russian supermarket might sit cheek-by-jowl with dollar bonds from an Indian bank.
There is also a greater move in the industry towards “benchmark agnostic” investing, according to Ken Lambden, chief investment officer of Baring Asset Management. Instead of sticking closely to benchmark weights, Barings just focuses on buying the stocks it wants, which might mean avoiding some of the state-owned enterprises that usually dominate EM indexes. “To do that and also be very conscious of benchmarks just doesn’t make sense,” Lambden told the summit.
A benchmark-agnostic approach has been particularly useful for investors wrestling with China’s growing dominance of emerging equity indexes. Despite all this, many argue that benchmarks still have a role to play, not least because institutional investors use them to measure asset managers’ performance. But the extent to which active managers can deviate from the benchmark is often restricted by their mandates from investors. This is measured by the so-called “tracking error”.
“It’s the nature of the industry – it’s very index-driven. And some clients want a very low tracking error,” said Richard House, head of EM fixed income at Standard Life Investments.
This can present problems for managers trying to outperform.
One criticism of traditional market cap-weighted indexes is that they encourage investors to buy what has already gone up, playing a role in the building of bubbles. For example, India has become a crowded trade, having been overweighted in most emerging market stock portfolios.
For its part, MSCI, the index provider, says it is willing to provide customized indexes to meet specific client needs, as well as differently weighted benchmarks based on factors or themes. Bond investors have also questioned the way indexes are structured – in general, the more debt a country issues, the higher its weight in benchmarks such as those run by JPMorgan. For instance, in its emerging currency debt index, Brazil’s weight is 10 percent, while Mexico, a stronger credit, is at 6 percent.
To address this, Lombard Odier Investment Managers (LOIM) has developed its own bond indexes using factors such as public-debt ratios, fiscal deficit, social imbalances, and size of economy. In LOIM’s Emerging Local Currency bond index, Brazil, Turkey, Malaysia and South Africa carry lower weights than in JP Morgan’s widely used GBI-EM benchmark index. LOIM also includes China and India, which are excluded from the GBI-EM.
LOIM’s index has outperformed GBI-EM by almost 5 percent in the year to end-October, but with a high tracking error of 4 percent.
“An average active manager would run a tracking error of 1.5-2.5 percent, and 2.5 percent would be quite extreme,” said Salman Ahmed, LOIM global strategist. “But if you look at the volatility of the EM local currency universe, it’s five or six times that.”
Other managers, such as SLI’s House, use an index to define the opportunity set, but then only invest in about half of the 60 countries in the hard currency bond index.
“If other people looked at it this way, it would lead to a much more efficient pricing of sovereign risk,” he said. “I don’t think many people would choose to be as long Russia as they probably are if they didn’t have to match an index.”