4th Quarter 2013 Commentary - ASTON/LMCG Emerging Markets Fund
4th Quarter 2013
Emerging Market equities posted modest gains during the fourth quarter, but continued to lag U.S. and developed market stocks. After a solid start in October, the group retreated in November and December on fears of interest rate increases, slower growth in China, and geopolitical concerns in Turkey. Emerging Markets were under considerable pressure throughout 2013 due to uncertainty related to the U.S. Federal Reserve’s monetary policy and the timing of the tapering of its quantitative easing (QE) bond purchase program. We saw a huge divergence in the stock market performance between Emerging Markets (EM) and the rest of the world. This is not surprising given that much of the turmoil plaguing EM was unique to those markets and did not have major ramifications elsewhere.
Earnings Quality Suffers
The Fund lagged its MSCI Emerging Markets Index benchmark during the quarter. Typically, the model factors we use have a fairly strong relationship with how the strategy performs. During the last several months, however, macroeconomic and geopolitical issues have weighed heavily on EM. Corporate fundamentals have not mattered as much and our model factors have been less effective and more volatile in emerging countries than other asset classes that we monitor. As a result, the strategy has had a difficult time adding value, affected more by country allocation, individual names, and risk factors than by our model inputs.
Among the major factor categories in the model—Valuation, Earnings Quality, and Market Dynamics—Quality was negative each month of the quarter and the major detractor among the three groups. At the country level, an overweight stake in Turkey detracted from performance as that market continued to underperform due to protests and political uncertainty, as did stock selection in Taiwain. Across sectors, Financials and Technology had the biggest negative impact. Our model did not work in these sectors, resulting in substantial relative underperformance. None of the model components worked in Financials during the quarter, making it difficult to add value in that sector. Within Technology, Market Dynamics factors worked but those in Valuation detracted from returns.
Stock selection was modestly positive overall, though, with the majority of the rest of the sectors doing well. The best stock selection came from Energy and Consumer Discretionary. Sector allocation added modestly to performance as well, helped by underweights in Financials and Energy. The best stock selection was in China and Brazil. Market Dynamics was the strongest of the major factor categories, driven by its Earnings Revision and Price Momentum components, the latter particularly in November and December. Though positive, the payoff from Earnings Revision was about half that of Momentum. Valuation factors were mixed, as they vacillated between positive and negative on an almost daily basis, making it difficult to capture notable gains.
In the current environment, the strength of different factor components continued to move in different directions and remain volatile from month to month. Consequently, it has been difficult to position the portfolio to capture any positive payoffs. We believe that maintaining a balanced approach to our model components is important, as factors remain volatile during this choppy period in Emerging Markets.
Whenever possible, we have strived to purchase stocks that have Value components, but also a catalyst such as Estimate Revision. While this has been positive overall thus far for stocks that are in the top quintile of our model, we’ve noted that results have been less significant within Emerging Markets than for other asset classes. Another striking observation has been the month-to-month volatility in EM versus elsewhere. There were only seven months in 2013 during which Value combined with Estimate Revision paid off positively, compared with nine months for developed market international equities, and 10 months for other asset classes. Given that we have positioned the strategy to have exposure to stocks that possess good Valuation combined with positive Estimate Revision and the payoff has been weak and volatile, the strategy has suffered.
Although valuations appear attractive, Emerging Markets still have a cloud over it in terms of geopolitical risk and macroeconomic uncertainty. Growth has slowed in many emerging countries, and investors seem to be taking a wait and see attitude toward the asset class. Five countries—Brazil, India, Indonesia, Turkey, and South Africa—will hold elections in 2014, possibly adding to the rocky performance as we await the outcomes of those elections and for the political environment to stabilize.
We continue to believe in the importance of balance in the portfolio against an up or down market by having more equal exposures across all of our major factor categories. This approach has worked well for us in the past and allowed the strategy to weather periods of higher market volatility. We will continue to monitor where we are in the market cycle by looking at valuation spreads, factor performance, and stock correlations to adjust the strategy’s exposure as necessary.
Lee Munder Capital Group, LLC
Note: Foreign securities involve risks related to adverse political and economic developments unique to a country or a region, currency fluctuations or controls. In particular, Emerging Markets securities tend to be more volatile and less liquid than securities traded in developed countries. 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.
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