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The Case for Active in Emerging Markets Has Always Been Strong. Why Do Investors Still Favor Index Funds?
Many investors have long used passive strategies to get exposure to developing markets, but now may be the time to venture into active and companies outside popular benchmarks.
Even though it takes specialized skills to navigate the fast-changing investment landscape of emerging markets, public pensions and other institutions have still largely piled into index funds to get exposure to these opportunities. Spurred on by geopolitical changes including Brexit and rising tensions between the U.S. and China, asset managers and others argue that there’s a strong case now for investors to move away from simple index funds and adopt a more active securities-selection approach to emerging markets.
Makena Capital, an outsourced CIO that partners with endowments and foundations, doesn’t use index funds, but instead capitalizes on market inefficiencies in countries like Brazil, China, India, and Russia using active management.
Instead of taking a macro view of trends in emerging markets, which can be short-lived and influenced by the latest news headlines, Makena has a bottom-up approach and hires long-only managers with deep knowledge of the companies in which they invest.
“We’d [rather] take a ten-year view knowing that there’s going to be ups and downs along the way, said Larry Kochard,” chief investment officer of Makena, which spun out of Stanford’s investment office and has $20 billion in assets under management. Kochard said endowments and foundations already take a more active approach to developing markets. Pensions and others are bigger users of passive strategies.
Emerging markets index funds end up favoring specific countries, sectors and large-cap stocks — many of which are state-owned. That means investors can easily make broad-based bets on a macro theme. But they lose out on fast-growing corporates, largely an under-researched dynamic group, and the potential to engage with company management on issues ranging from financials to environmental and sustainability goals, explained Jack Nelson, a portfolio manager on the sustainable funds group at Stewart Investors. The five largest stocks in the MSCI EM index, for instance, are all technology-oriented companies comprising nearly a fifth of the total; China, South Korea and Taiwan make up the bulk of the countries represented.
“Many people are naturally worried about China because of things that have happened, which are legitimate fears — whether it’s the geopolitical risk with Trump and now with the new president, or in terms of the greater antitrust enforcement,” Kochard said. “It overshadows what we still think is the fact that there is a huge number of companies that have enormous markets ahead of them.”
Makena’s asset allocation to listed emerging markets stocks has increased over time to about 40 percent of the firm’s entire public markets bucket. With its active approach, 86 percent of Makena’s holdings in emerging markets end up being different from the companies in the MSCI EM index.
Stewart Investors, which has been actively investing in emerging markets since 1992, uses a bottom-up approach precisely because of the markets’ diversity.
In a typical year, Stewart, which has its largest holdings in India, China and Taiwan, conducts 1,500 meetings with management teams so it can get to know these businesses directly, many of which are owned by families. For example, Stewart follows directors, many of whom are family members with a controlling stake in a company, so it can select those that the managers believe have the “competence and honesty” to flourish long term.
“Over thirty years we’ve built up a knowledge of local businesses and families and their reputations,” said Nelson. “If you’re going to own a stock for 6, 12, 18 years, you better be sure that the people you are investing alongside aren’t the kinds of people that are going to disadvantage minority shareholders.”
The approach also aligns with the firm’s environmental, social, and governance goals and investments. Family-owned businesses are more inclined than peers to make changes for the long haul, because these businesses are often multigenerational and closely tied to their names. “Every company says we’re here for the long term; it’s more credible when you’re speaking to the owner of the company,” Nelson said.