Emerging markets are a prime target for active investors

The perceived lack of transparency and communication on the part of many EM companies makes them an ideal hunting ground for skilled active managers

Emerging markets (EM) have long been overlooked by money managers who shied away from political instability, economic uncertainty and volatile markets. In fact, some investors still regard the region as a purely short-term tactical investment.

 

Ben Robins, portfolio specialist at T. Rowe Price, begs to differ. ‘This is a very traditional, stereotyped view that no longer accurately describes today’s emerging market asset class. It is time to get beyond traditional thinking and dispel those lingering misconceptions.’ According to Robins, the region offers a breadth of opportunities for active investors who are looking to capitalise on both short-term yields and long-term growth.

‘If you want to benefit from the full opportunity set available, you can’t just rely on passive investing. EM stocks tend to be like hidden gems – hard to find and even harder to recognise’

Scott Berg, portfolio manager, T. Rowe Price

With varying levels of liquidity, valuations and corporate governance, it is fair to say that emerging markets provide a riskier environment than developed countries. In addition to that, regulatory frameworks can be weak and sometimes fail to provide enough guidance to navigate the investment landscape successfully. The lack of transparency and communication on the part of EM companies can make it difficult for foreign investors to separate the wheat from the chaff. Also, if only investing in the index, that may lead you to companies that have ownership structures that are not necessarily aligned with the interests of minority shareholders, or to companies that do not have a solid focus on environmental, social and governance (ESG) issues.

Mind the information gap

According to Scott Berg, portfolio manager at T. Rowe Price, the ability to conduct in-depth research and identify high-quality companies with low-leverage, cycle-tested management teams is imperative to any investment approach. Sufficient resources and a research platform that can effectively synthesise industry and stock-specific analysis are vital in that regard. This is especially true in emerging markets where research coverage can be patchy and information is not as easily available as in developed countries. Negative news headlines fuel price anomalies.

‘It may sound counterintuitive, but as an active investor, the inefficiency around research coverage actually plays to our advantage. Unlike passive investors, we are able to dig deeper to uncover idiosyncratic names and sectors that can provide greater alpha,’ Berg says.

Yet, it is not just information asymmetry that makes emerging markets a difficult terrain for passive investors. Unlike their active counterparts, passive investors, with their individualistic investment style, cannot benefit from team synergies either.

‘Where access to information is limited, teamwork plays an even more important role,’ says Berg. He actively encourages equity and fixed income teams to work together, for example by sharing research findings. ‘Fixed income specialists can provide what some people on the equity side call a “weather forecast”, so equity divisions often use fixed income teams’ top-down analyses,’ he explains.

Passive approach fails to capture the real opportunities

Passive investing also does not live up to the challenges or opportunities that emerging markets can offer. Tracking an index can be limiting in emerging markets, which, unlike their more homogeneous developed market peers, represent a broad mix of different economic, political and financial systems. Simply following an index does not do justice to this diversity as investors do not get the full exposure to the range of opportunities EMs can offer, be it on a sector or a country level.

Not only are up and coming industries such as fintech and healthtech often underrepresented, indices also tend to focus on just a small group of emerging countries. For example, five economies make up more than three quarters of the MSCI Emerging Markets Index, which is most heavily weighted in China, Taiwan and South Korea, closely followed by India and Brazil.

What’s more, indices are backward looking and often slow to evolve. Investors need to stay on top of trends to identify the best opportunities.

An active approach can help tackle these issues head-on while avoiding the pitfalls of EM investing. ‘If you want to benefit from the full opportunity set available, you can’t just rely on passive investing,’ Berg says. ‘EM stocks tend to be like hidden gems – hard to find and even harder to recognise.’

In this current environment, there is also a lot of extra insight that active management can bring in terms of assessing the health of companies in a crisis and navigating their long-term prospects in a changing world.

Know what you want

At the end of the day, it is about making more informed investment decisions – and passive investors, relying on the broad-brush perspective of indices, have a hard time reaching the same level of insight that is available to active investors. That is why Berg suggests to ‘put the benchmark to one side’ when making stock decisions: ‘Extracting the highest returns is about focusing on the best that this new EM world has to offer and skipping the rest.’

This also means that investors need to see through negative headlines about economic growth and focus on the prospects of individual companies instead. Berg names Brazil and China as two examples: ‘In Brazil, there are high-quality companies in the banking and retail sectors that have widened the gap between them and their competition as the recession has bitten. They are expected to be much better positioned once the economy stabilises.’

According to Berg, the situation in China is similar: ‘Despite a general economic slowdown, growth rates in social media, gaming and online spending have been impressive. Companies positioned to benefit from that future growth should continue to do well.’

‘What I really love is finding stock ideas where there is inefficiency and where the mosaic of fundamentals is complex,’ Berg continues. ‘Those ideas are plentiful within emerging markets, but only fundamental research and teamwork will enable you to uncover them.’

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