Manager Insight – Eye on Emerging Markets
The ways in which investors make money in Emerging Markets has changed markedly over time. Long ago, Europeans sent goods off in slow-moving ships and hoped the ships would return … someday. Today, people can transact online at the speed of light in places once unreachable in a lifetime, and overseas equities are recognized as a necessary part of a diversified investment portfolio.
The opportunity to invest in Emerging Markets has evolved at astonishing speed during the last 25 years. Following the fall of the Berlin Wall in 1989, capital markets opened up so quickly and so broadly that when we speak today of investable foreign markets, we speak of more than 45 countries outside of the United States, of which roughly 21 encompass emerging economies.
Investment returns for Emerging Markets over these years have by no means been smooth sailing, however, as emerging equity markets have had their booms and their busts—busting notably in 1995 and 1998. The asset class was not immune to the global financial crisis of 2008-2009 either, falling more than the U.S. equity market (though recovering more quickly). Yet, we think the returns have been compelling over the long-term, and the beginning of the 21st century has provided an environment of rapid and mostly positive transformation.
Changing Landscape, New Opportunities
Important changes continue to take place, demanding an investment approach that can anticipate and react quickly. We see four major aspects to the transformation in Emerging Markets, including both pitfalls and opportunities, which we think require the skill and experience of active management to navigate:
1. The acceptance of foreign capital investing has opened the door for long-term investors, though it has also allowed in so-called “hot money”
The rapid development of information systems and interconnected equity and currency exchanges has meant that once-remote markets have become available for foreign investing. Governments in Asia, Africa, and Latin America have embraced public equity financing, in varying degrees, as an essential part of economic development. Although this enhanced access to capital is a good thing, it can also lead to so-called “hot money” moving in and out of markets rapidly, leading to swings in valuation that can exaggerate both booms and busts at less liquid exchanges.
We think that valuation discipline and a long-term commitment to capital markets are an essential part of this new era of investing. Strategies that have an objective and systematic view of a company’s appropriate valuation can adapt and potentially avoid some of the pitfalls created by hot-money flows.
2. Unforeseeable events can overwhelm concentrated company and country positions
The rapid, worldwide improvement in financial transparency and steps toward the unification of accounting principles has made traditional financial analysis much more important to investment returns in Emerging Markets. This leads to the temptation to approach the situation in a way similar to how U.S. investors have done within their own market, managing risk one stock at a time. This has led to extremely disappointing experiences in the past due to macroeconomic events like the “Peso Crisis” and the “Thailand Banking Crisis.” Unpredictable global and local surprises can still upend bottom-up analysis and stock picking within Emerging Markets.
We think sophisticated risk management that can deliver deeper and more thoughtful diversification is imperative to being a successful investor within emerging economies, as diversification based solely on market-cap based index weightings for countries and companies is a poor substitute for an analysis of the fundamental risk and individual market dynamics.
3. The types of companies available for investment in Emerging Markets are becoming more sophisticated and globally competitive
Many Emerging Markets are transforming beyond “emerging,” and list companies that are every bit as competitive as those in developed markets. Countries that constitute the bulk of the group have typically grown rapidly due to two significant competitive advantages—low labor costs and a supply of energy and/or commodities. Investments in Emerging Markets historically have been to provide capital to develop commodity-based industries and the infrastructure needed to develop and transport those commodities to the developed world. During the late-20th century, investment expanded to help locate the industries that used these commodities (e.g. steel, automobiles, textiles) to countries with labor cost advantages.
The important change in the past several years has been the new force of companies that are truly world-class innovation leaders and competitive enterprises on a global scale. While Korea and Taiwan host some of the fastest growing of these companies, India, Brazil, and even Mexico are home to newly emerging and re-emerging companies. Leadership in industries as diverse as electronics, consumer products, healthcare, as well as the well-known and established companies that dominate labor-cost-sensitive industries, has broadened the spectrum of quality investing within Emerging Markets.
Other countries are quickly entering the competitive landscape with unique labor cost and skill advantages. The added benefit of political stability has helped markets in Indonesia, the Philippines, and Turkey to post impressive growth in Gross Domestic Product as well as strong stock market returns in recent years.
We think successful investment techniques must be able to adapt to this ever-changing opportunity set.
4. Giant, uncompetitive dinosaur companies still exist, but can be avoided
Emerging equity markets are newly dynamic, but certainly not new. Large oil companies, electric power companies, quasi state-owned banks, and telephone companies have long used equity markets as a source of capital. Some of these companies are still dinosaurs—uncompetitive and existing only through the support of the local government that protects them. Although they are often a significant part of Emerging Market indexes, that doesn’t mean they necessarily belong in the portfolio of American investors.
We think active Emerging Markets managers need to account for company quality and be aware of company growth prospects. Companies that are the most competitive need to be separated from poorly managed and government-protected enterprises in order to achieve long-term success. We believe the presence of these uncompetitive, government supported dinosaur companies is an undesirable part of Emerging Markets indexes.
How to Navigate This Changing Market
At Lee Munder Captial Group (LMCG), our strategy seeks to combat the pitfalls and take advantage of the opportunities presented by dynamic emerging equity markets. We pay close and constant attention to valuation distortions caused by hot-money flows and the natural boom and bust cycle. We apply advanced risk-measurement and diversification approaches in constructing the portfolio, designed specifically for Emerging Markets. We actively discriminate quality companies from the dinosaurs, and adapt to the ever-expanding opportunity set of companies that are changing the nature of the global investing.
Our Emerging Markets investment team has worked and invested in global markets together for more than a decade, with success in adding value and managing risk in institutional portfolios. We think that in the ever-evolving area of Emerging Markets that a truly active investment management approach can overcome the structural limitations of indexing in seeking to take advantage of inefficiencies in developing regions of the globe.
Important Risk Information: Emerging Markets securities tend to be more volatile and less liquid than securities traded in developed countries. Foreign securities involve risks related to adverse political and economic developments unique to a country or a region, currency fluctuations or controls. In addition, Emerging Market securities are subject to risks associated with less diverse or mature economic structures, less stable or developed political and legal systems, national policies that restrict foreign investment, and wide fluctuations in the value of investments.
Before investing, consider the Fund’s investment objectives, risks, charges, and expenses. Contact 800 992-8151 for a prospectus or summary prospectus containing this and other information. Please, read it carefully. Aston Funds are distributed by Foreside Funds Distributors LLC.
The information contained in this article is provided by Lee Munder Capital Group (“LMCG”), a subadviser utilized by Aston Asset Management, LP (“Aston”). LMCG is not an affiliate of Aston and their views do not necessarily reflect those of Aston.
This material is not intended to be a forecast of future events, does not constitute investment advice, and is not intended as a recommendation to buy or sell any security. Since the date of this report, economic factors, market conditions and LMCG’s views of the prospects of any particular investment may have changed. Investors should consider the investment objectives, risks and associated costs carefully before investing. Forward-looking information is subject to certain risk, trends and uncertainties that could cause actual results to differ materially from those predicted. Past performance is no guarantee of future results. For more information about Aston Asset Management, LP and its subadvisors, please call 800-597-9704, or visit www.astonfunds.com.