The year-to-date performance of passive emerging markets (EM) vehicles begs the question whether or not active management continues to offer value to long-term investors.
- The Morningstar EM ETF category returned 13.7% through August 31, 2016. This compares to an average return of 12.5% for the broader EM category and 14.7% for the MSCI EM benchmark, which measures the equity performance of global emerging markets.1
- As we discussed in a recent blog post, the principal driver of the strong EM benchmark performance in 2016 has been the global hunt for yield rather than meaningful improvements in company fundamentals. This has manifested in a massive mean reversion trade in commodity-oriented currencies and bourses this year after significant declines in U.S. dollar terms in 2013-2015.
However, the long-term case for passive investing is, in our view, by no means compelling or straightforward. Investing in the MSCI EM benchmark is fraught with a number of significant drawbacks. In our view, the plain fact is that the MSCI EM Index is misrepresentative of the EM opportunity set from a sector, country and company perspective.
- The benchmark is highly weighted in structurally less attractive commoditized sectors, with limited structural growth―energy/materials and financial services comprise 14% and 25% of the benchmark, respectively.
- Additionally, investors get disproportionate exposure to areas of the market that are more subject to the cyclical pressures of the global economy, high levels of regulation or structural challenges such as industrials, utilities, telecoms, autos and consumer electronics manufacturing.
The index positioning greatly downplays the importance of some countries and exaggerates the importance of others. This is particularly true of the two largest (and fastest growing) economies in the developing world―China and India.
- China contributes 17% of global GDP but represents a mere 3% of the MSCI ACWI. China’s contribution to developing world GDP stands at 30% vs. a 27% weight in the MSCI EM Index, a float-adjusted market capitalization index that measures the equity performance of global emerging markets.2,3 This weight doesn’t take into account China’s economic size―which is as large as India, Brazil, Korea, Indonesia, Russia, Turkey and Mexico combined―and its enormous influence on the growth of other EM countries.
- India contributes 3%4 of global GDP and represents just 0.9% of MSCI ACWI and 8% of MSCI EM.
- Meanwhile, Korea and Taiwan, which by most standards have already converged with the developed world, represent a combined 27% of the index. The overwhelming capitalization of South Korea and Taiwan bourses is comprised of cyclical, capital-intensive manufacturing with little competitive differentiation and a financial services sector that is largely ex-growth, with unusually high credit and insurance penetration. This means investors in vehicles that passively track MSCI EM are getting high exposure to economies that exhibit mature developed world characteristics.
Finally―and very importantly, in our view―is the significant index weight occupied by state-owned enterprises (SOEs), many of which are run for strategic rather than economic purposes. MSCI EM weights, like those of most equity benchmarks, are derived largely from free-float market capitalization. This methodology amplifies the importance of SOE behemoths. Since these stocks represent a sizeable part of the benchmark, investors in capitalization-weighted indices and ETFs will have exposure to these companies irrespective of their growth potential or quality of governance.
- SOEs comprise 30% of the MSCI EM
- SOEs comprise 45% of MSCI China5
It is impossible to dispute recent substantial outperformance of the MSCI EM benchmark and/or the meaningful gains in large-cap SOEs (Gazprom and Banco do Brasil up 18% and 99% respectively YTD in USD6). We have pointed out before, however, that these gains are unsustainable, and not necessarily linked to underlying fundamentals.
We are witnessing a massive “mean reversion” trade, underpinned by the global “search for yield” context. Trading these kinds of moves may be more suited to shorter-term, tactical investors. That is if they can get it right serially.
For longer-term investors, in our view, company fundamentals are what matters. This is where investing with a proven product with a consistent process focused on rigorous stock selection makes a difference. We believe that a long-term investor will be best served by gaining exposure to the areas of EM that benefit from structural tailwinds such as rising affluence, the ubiquity of technology and platforms, and the formalization of economies.
Our fundamental investing approach remains anchored towards a concentrated portfolio of structurally advantaged businesses—ones with sustainable competitive advantages and growth options which the market fails to adequately appreciate. We believe this approach—which has underwritten significant competitive long-term outperformance—is durable.
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1 Source: Bloomberg.↩
2 Source: IMF. GDP data is as of 12/31/15 and is the most recent data available.↩
3 Source: FactSet. Data as of 8/31/16. Returns are in USD and based on the MSCI EM Index sector and country returns.↩
4 Source: World Bank as of 12/31/15.↩
5 Source: MSCI, CITIC . The MSCI China captures large and mid-cap representation across China H shares, B shares, Red chips and P chips. With 149 constituents, the index covers about 84% of this China equity universe.↩
6 Source: Bloomberg as of 8/31/15.↩
Mutual funds are subject to market risk and volatility. Shares may gain or lose value.
Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Emerging and developing market investments may be especially volatile.
The discussion of specific securities are for illustration purposes only and are not a recommendation to buy or sell.
The MSCI Emerging Markets Index is designed to measure the equity market performance of emerging markets. The index is unmanaged, includes the reinvestment of dividends and cannot be purchased directly by investors.
These views represent the opinions of the Portfolio Manager at OppenheimerFunds, Inc. and is not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.