The Advantages of a Multi-Asset Approach in Emerging Markets. Investment Focus

Transcription

1 Investment Focus The Advantages of a Multi-Asset Approach in Emerging Markets After 30 years of significant but non-uniform economic growth, the developing world has grown so disperse that the very term emerging markets has been criticized as being too broad and obsolete. In our view, it is precisely this heterogeneity that beckons a multi-asset structure. We believe that a well-considered emerging markets strategy today needs to deploy different portfolio construction methods indeed, different fields of human expertise at different times to unlock the latent value in the markets.

2 2 Over the past decade, assets under management have grown steadily in the emerging markets equity and fixed-income asset classes, driven by strong fundamentals and growth prospects for emerging-market countries. However, these assets have mostly been allocated to benchmark-aware strategies in exchange-traded funds (ETFs), passive benchmark tracker funds, and low-tracking-error active funds.¹ In reality, the MSCI Emerging Markets Index the equity benchmark for most passive and low-tracking-error funds represents a shrinking portion of the opportunity set in the emerging markets. In this paper, we discuss how the emerging-market investment universe is much broader than the large-cap equity space, and how different parts of the emerging-market equity and fixed income universes are attractive at different stages of the economic cycle. Correlation between Emerging and Developed Equity Markets The concept of diversification benefit plays a key role in many asset allocation frameworks. However, as we are reminded every few years, correlation is often unstable. Exhibit 1 shows the correlation of returns between the MSCI Emerging Markets Index and the MSCI World Index (representing developed countries). In the late 1980s, many of the world s asset allocators began to diversify their equity exposure into emerging markets and they achieved some diversification benefit. However, the risk reduction through correlation was hardly stable. For example, a sharp jump in correlations from 1988 (-0.2) to 1991 (+0.8) meant a substantial increase in overall portfolio volatility on the basis of increased correlation alone. The instability of correlations throughout the 1990s made quantifying the benefits of diversification difficult at best. More recently, this relationship has stabilized as it has grown. In our view, this structural increase in correlation between capital markets in emerging and developed nations represents more than a statistical coincidence. Over the past 20 years, many capital controls have been removed, currencies permitted to float, and cross-border trade has increased. In short, the correlation has risen with globalization, and this process has not been stopped by occasional short-term distortions. As the world gets smaller, so too does the diversification benefit investors receive from emerging markets beta. As the pattern of returns one expects from broad-based emerging markets begins to resemble that of developed markets, our research shows that, like in the developed world, diversification can be found by looking deeper within the broad classification. Multiple Asset Classes Have Evolved within Emerging Markets Emerging markets style (growth/value) and emerging markets size (large/small) have become much more independent factors within the emerging markets asset class. Exhibit 2 shows the correlation between size (large minus small) and style (growth minus value) factors from August 2000 through July It is important to note that exposure to emerging markets growth was once similar to exposure to emerging markets large cap, and exposure to value was once similar to exposure to small cap. Recently, the correlation between these factors has decreased sharply, and now the two factors are, in effect, independent; we believe there are at least four different asset classes, which could be split even further (as we will see later). A specialization of the emerging markets asset class appears to have occurred, which suggests more tailored options for investors. Our research 2 has confirmed that investors may now exploit the benefits of style diversification across emerging market equities by structuring portfolios along style lines. As has occurred with other major asset classes, the structural changes, and resulting expansion, of the number of investable companies and countries has broadened the emerging markets opportunity set. For example, we examined the emerging markets equity manager universe, 3 categorizing managers into five groups (Deep, Relative, Core, -at-a-reasonable-price or GARP, and Exhibit 1 Correlation of the MSCI Emerging Markets Index and the MSCI World Index Trailing Correlation Week 24-Month 36-Month -0.2 Jun 88 Jul 90 Aug 92 Sep 94 Oct 96 Nov 98 Dec 00 Jan 03 Feb 05 Mar 07 Apr 09 May 11 June13 As of 30 September 2013 It is not possible to invest directly in an index. Indices are unmanaged and have no fees. The information in the chart above is for illustrative purposes only and does not represent any product offered by Lazard. Source: Lazard Asset Management ELEVEN platform, MSCI, Bloomberg

3 3 Exhibit 2 Emerging Markets Style and Size Correlation Correlation Aug 00 Mar 03 Oct 05 May 08 Dec 10 Jul 13 As of July 2013 The size factor is based on the large- and small-cap stocks in the MSCI emerging markets universe, and the style factor is based on the MSCI and indices. It is not possible to invest directly in an index. Indices are unmanaged and have no fees. The information in the chart above is for illustrative purposes only and does not represent any product managed by Lazard. Source: Lazard Asset Management ELEVEN platform, MSCI, Bloomberg ), based on holdings. Our goal was to determine whether the five style buckets were discrete, and if emerging markets equity styles had evolved. The chart on the right in Exhibit 3 plots these five style groups on a holdings-based matrix 4 for the five-year period ending 30 June The graph demonstrates that there are now five unique and non-overlapping emerging-market equity styles. The chart on the left in Exhibit 3 shows what this universe looked like nine years ago (i.e., the same style groups mapped for the five-year period ending 31 December 2004). At that time, manager styles were more blurred. We also found many examples that highlight source of return differences, including market capitalization, country, and industry, which contributed to differentiated patterns of performance over medium- to long-time periods. In summary, the development of emerging markets as an asset class over the past ten to fifteen years has provided managers the opportunity to exploit growing country, industry, and security investment trade-offs. In our opinion, this has allowed investors to benefit from specialized patterns of return and risk, according to their objectives., value, core, and sub-style cycles exist within emerging markets, and blending styles can now be considered at a portfolio structure level. Moving to a multi-manager structure may require close evaluation of sub-style patterns of performance in the context of manager selection (e.g., a Relative manager may better complement a GARP manager than a Core manager). Recent Developments Emerging-market economies are currently in a more favorable macroeconomic position than their developed-market peers. Emerging-market countries, in general, have stronger GDP growth prospects, lower debt levels, and are in better fiscal condition than those countries in the developed world. 5 Assets under management have grown steadily over the past decade in the asset class, as retail and institutional clients align their portfolios with this wider economic story. However, despite the substantial growth in assets, the market has not been as sophisticated in allocating capital as it has been in developed markets. Emerging-market equity assets are mostly allocated to benchmarkaware strategies in exchange-traded funds (ETFs), passive benchmark tracker funds, and low-tracking-error active funds. 6 This naturally leads to a large-capitalization bias and sector concentration, with many investors holding similar companies. Exhibit 4 illustrates that as the Exhibit 3 Five Emerging-Market Style Groups Are Now Present Large 2004 Large 2013 Mid Mid Small Small Core Core EM Deep EM Relative EM Core EM GARP EM As of 30 June 2013 The information in the chart above is for illustrative purposes only and does not represent any product offered by Lazard. Source: Lazard, Callan Associates

4 4 emerging-market universe grows, the MSCI Emerging Markets Index, which is the benchmark for most passive and low tracking error funds, represents a shrinking portion of the opportunity set, as shown in the top chart. We believe the opportunity is much broader than the large cap equity space and that different parts of the investment universe are attractive at different stages of the economic cycle. Similarly, the market capitalization of emerging-market debt has grown significantly in the last decade, also local-currency and corporate debt have risen in prominence increasing the size and diversity of the opportunity set, as shown in the bottom chart of Exhibit 4. In the following section, we examine the fundamental drivers of return patterns for various emerging-market investments that can be harnessed to generate favorable risk-adjusted returns. In addition, we discuss how, by adding flexibility in terms of styles, investors can take better advantage of the opportunities presented in different economic settings. Aligning a portfolio with macroeconomic views is no trivial task, but it may be achievable by examining the fundamental drivers of performance for various securities in emerging markets. Exhibit 4 The MSCI Emerging Markets Index Represents a Shrinking Portion of the Emerging Markets Opportunity Set 52% 1, ,015 2,205 2,187 2,576 2,795 2,725 2,616 2,419 41% 1,787 1,582 41% 41% 39% 42% 31% 30% 29% 30% 31% Number of securities in MSCI EM Index Additional number of Securities in MSCI EM IMI Number of securities in the MSCI EM Index as % of the total number of securities in the MSCI EM IMI EM Market Capitalization ($ Billions) EM Sovereign EM Corporate EM Local As of 31 December 2012 This information is for illustrative purposes only and does not represent any product offered by Lazard. Source: MSCI, J.P. Morgan Opportunity Sets within the Emerging Markets Small and Profitable Companies In our view, smaller companies in the emerging markets offer a differentiated investment opportunity. Smaller companies tend to focus more on domestic consumption and profitable companies tend to borrow less: in our opinion, the combination makes smaller companies generally less susceptible to global shocks as compared to larger firms. Furthermore, analyst coverage tends to be relatively low as few investors are able to commit specialists to the task of fundamental research in this area. By isolating profitable firms from the myriad small companies in the emerging markets, investors can focus on management teams that have delivered on their primary objective something which must next be vetted with extensive fundamental analysis. Because of the higher level of stock-specific risk, investing in smallcap stocks requires specialized knowledge of the company, country, and the competitive environment, as well as a detailed assessment of company management that can be sourced through on-site visits and a forensic examination of financial reports. Growing Companies We believe growing companies offer the highest return potential and, commensurately, pose the greatest risks. To manage these risks, we believe investors should focus on companies whose future earnings growth is not already reflected in consensus estimates (and stock prices). Put another way, they should focus on those companies with under-appreciated growth potential. In our opinion, these companies tend to have higher and more stable levels of earnings growth and higher capital expenditures on their balance sheets. Growing companies tend to be more expensive on a P/E basis as they often require debt to fund their growth. Poor security selection in this segment of the market can be particularly costly, and selecting winners can be extremely profitable, so, investors must carefully assess management s ability to execute their plans. We believe that opportunities in growing companies provide a high octane complement to a broad portfolio of emerging markets investments. Established Companies Established emerging-market companies are often global companies that have successful franchises. These companies generally have sustainable profitability, free cash flow, attractive valuations, and high dividend payout ratios. Emerging-market currencies can be valued as a broad reflection of a country s macroeconomic fundamentals. Compared to equities, they generate an uncorrelated return stream, even though volatility can be high at times. Shifts in government policy and changes in currency regimes across the emerging world drive performance in this asset class, meaning an investor needs a detailed understanding of the fiscal and monetary policy conditions across the full spectrum of the emerging world.

5 5 The emerging-market debt universe spans a broad spectrum of local currency, hard currency, corporate, sovereign, and quasi-sovereign bonds. Investors have a wide range of instruments to use in this asset class; thus, the keys to success lie in identifying where market or pricing inefficiencies exist and capitalizing on those inefficiencies across several different instruments. Investments for Different Environments Small, growing, and established companies all benefit from different business environments. Small companies in the emerging markets benefit from periods of favorable domestic demand dynamics in their home country and rely less on global economic growth rates. They are therefore less susceptible to today s slower growth in the developed world where they are unlikely to generate revenue. While small companies earnings may not be directly tied to global growth, their returns are still correlated to global market performance. In particular, they are subject to swings in risk aversion because they tend to exhibit a high beta relative to the market. However, the resulting volatility in share prices creates opportunities for investors who have a more nuanced understanding of company fundamentals and domestic economies. Growing emerging-market companies will benefit from periods in the business/economic cycle of high liquidity and expansive monetary policy. In this setting, we believe companies with aggressive growth strategies via high capital expenditures (capex) will be able to find more favorable financing terms. As growing companies are expanding capacity, either domestically or internationally, by focusing on capex, there needs to be a high conviction about future cash flow to sustain growth. Conversely, under tighter liquidity, requiring a high level of debt is a negative attribute. In this environment, we believe growing companies will face difficulties financing further capex and sustaining growth. Investors in growing companies must be attuned to dramatic swings in asset prices and understand the factors that are driving these volatile moves. Opportunities are created when the market s reaction is not aligned with the fundamentals of the company and particularly the sustainability of the growth profile. Growing companies will generally outperform during rising markets when visibility into future cash flows is high. Established companies tend to gain an advantage over growing and small companies when liquidity tightens, as they can use their stronger balance sheets to increase market share. In general, we expect established emerging-market companies to outperform during periods of uncertainty and when there is elevated dispersion in equity market fundamentals in the emerging markets. An emerging-market currency portfolio benefits from periods when government policy has significant influence and when there is clear differentiation between the policy agendas of different emergingmarket nations. suffer when monetary policy in emerging markets eases, local interest rates fall, and there is a low level of policy dispersion in emerging markets. Emerging-market debt benefits when there are idiosyncratic inefficiencies in credit spreads, local and external yield curves, and exchange rates. Emerging-market debt suffers when companies are having difficulty obtaining debt financing, in the case of corporate debt, and when systemic factors in emerging markets are driving credit spreads and yields, which applies to all categories of emerging-market debt assets. Exploiting the Opportunity Lazard Emerging Markets Multi-Strategy In our view, as capital markets become broader and deeper, it is increasingly difficult for an investment professional to simultaneously research global mega-cap names, fast-growing domestic players, currencies, and fixed income. While there are definite synergies between the work that our emerging-market investment professionals undertake at Lazard, we encourage specialization not only within an asset class but also more narrowly in an investment style or sub-asset class. Lazard Emerging Markets Multi-Strategy invests across five broad strategies, which serve five distinct roles within a portfolio, with the help of five dedicated teams, as summarized in Exhibit 5. As has occurred with other major asset classes, the structural changes, and resulting expansion, of the number of investable companies and countries has broadened the emerging markets opportunity set. Simply dividing and then blending the emerging world s investment landscape in this way is no guarantee of success. Different market conditions call for different portfolio configurations, so the next step is to align the portfolio with the economic environment in the emerging markets. Given that there are no clear delineations between economic stages, the Lazard Multi Strategy team forecasts the economic environment over the next 6 to 12 months by assigning weights to four economic contexts: Panic, Differentiation, Expansion, and Mania (a framework called the Economic Context Assessment). We utilize a set of macroeconomic considerations and hundreds of indicators associated with each one. Then, we perform a qualitative analysis of quantitative information to determine a probability-weighted estimate of the four economic contexts. This Economic Context Assessment determines the most appropriate portfolio positioning. In simple terms, if our analysis shows that liquidity will likely improve in six months, increasing exposure to growing companies might be appropriate. On the other hand, if the probability of a double-dip recession in the United States increases as a result of fiscal policy developments, the equity exposure will likely shift to established companies that can weather the storm and emerge stronger than competitors. Exhibit 6 details three broad portfolio stances and how the underlying strategy allocations change in line with our assessment of the market.

6 6 Exhibit 5 Investment Strategies in Lazard Emerging Markets Multi-Strategy Opportunity Set Strategy Number of Lazard EM Investment Professionals* Initial Screen Typical Number of Stocks Requiring Fundamental Analysis Typical Number of Positions Small Companies Small Cap 4 ~2,800 Companies Stocks Growing Companies 6 ~800 Companies Stocks Established Companies 6 ~800 Companies Stocks 7 ~70 Countries N/A Securities 6 ~60 Countries N/A *Vice President and above, as of 30 September 2013 Exhibit 6 Hypothetical Portfolio Allocations Small Cap 4% 10% 42% Bullish Neutral Defensive 15% 29% This information is for illustrative purposes only. Small Cap 6% 25% 22% 25% 22% Small Cap 8% 45% 30% 10% 7% Conclusion Embracing a flexible asset allocation approach in the emerging markets can equip an investor to take better advantage of, and protect against, market fluctuations. Understanding the business cycle and where individual companies fit within it is an advantage when building strategies from the bottom up and when allocating capital between strategies. Exhibit 7 summarizes various asset classes in the emerging markets and the circumstances that we believe are most and least favorable to their performance. This knowledge gains in practical value when aligned with a thoughtful macroeconomic forecast, as the combination can help an investor identify an optimal asset allocation mix at any point in time. We apply these principles in our emerging markets multiasset portfolios, allowing us to adapt our equity exposure and blend in a combination of debt and currencies to suit the opportunity. We believe this flexibility is an essential quality that enables investors to keep pace with changes in the business environment across the globe and within the emerging markets.

7 7 Exhibit 7 Expected Performance across Asset Classes in Emerging Markets Asset Class Opportunity Set Strategy Focus When Expected to Outperform When Expected to Underperform Increasing Volatility Equity Small Companies Small Cap Finding value in markets where there is considerably less analyst coverage Growing Companies Established Companies High and stable levels of earnings growth and capex Sustainable profitability, free cash flow, attractive valuations, high payout ratios When there are favorable domestic demand dynamics in EM In periods of rising markets when visibility into future cash flows is high In periods of uncertainty and elevated dispersion in EM equity market fundamentals When domestic demand in EM is subdued, external factors are buoying global growth and exports are driving economies in EM In periods of cyclical slowdown when markets penalize high levels of capex and the environment is more challenging for new entrants looking to gain market share across industries When markets are optimistic about growth prospects in EM and capital is flowing freely to higher-yielding assets, allowing new entrants across industries to access financing, thus taking market share from more established companies Fixed Income Local currency, hard currency, corporates, sovereigns, and quasi-sovereigns Shifts in government policy and changes in currency regimes across the emerging world Where there are idiosyncratic inefficiencies in credit spreads, local and external yield curves, and FX rates When policy in emerging markets exhibits significant influence and when policy dispersion is high When companies in EM are having difficulty obtaining debt financing, and systemic factors in EM are driving credit spreads and yields When monetary policy in emerging markets is easing, local interest rates are falling, and there is a low level of policy dispersion in EM This information is for illustrative purposes only. Notes 1 Source: EPFR 2 Refer to the Lazard Investment Research paper Does Style Matter in Emerging Markets? available at: 3 Universe as defined by Callan Associates. 4 MSCI has developed security-level style scores based on multiple fundamental ratios that classify stocks as value or growth. 5 Source: IMF 6 Source: EPFR Important Information Originally published on 15 November Revised and republished on 25 June Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the date published and are subject to change. This paper and all research and materials enclosed are the property of Lazard Asset Management LLC. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Small- and mid-capitalization stocks may be subject to higher degrees of risk, their earnings may be less predictable, their prices more volatile, and their liquidity less than that of large-capitalization or more established companies securities. Emerging-market securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging-market countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in emerging-market countries. Investments in global currencies are subject to the general risks associated with fixed income investing, such as interest rate risk, as well as the risks associated with non-domestic investments, which include, but are not limited to, currency fluctuation, devaluation, and confiscatory taxation. Furthermore, certain investment techniques required to access certain emerging markets currencies, such as swaps, forwards, structured notes, and loans of portfolio securities, involve risk that the counterparty to such instruments or transactions will become insolvent or otherwise default on its obligation to perform as agreed. In the event of such default, an investor may have limited recourse against the counterparty and may experience delays in recovery or loss. The strategies invest in emerging-market debt positions. The strategies will generally invest in debt investments denominated in either US dollars or local emerging market currencies. As such, an investment in the strategies is subject to the general risks associated with fixed income investing, such as interest rate risk and credit risk, as well as the risks associated with emerging markets investments, including currency fluctuation, devaluation, and confiscatory taxation. The strategies may use derivative instruments that are subject to counterparty risk. The strategies will invest in securities of non-us companies, which trade on non-us exchanges. These investments may be denominated or traded in both hard and local currencies. Investments denominated in currencies other than US dollars involve certain considerations not typically associated with investments in US issuers or securities denominated or traded in US dollars. 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