2nd Quarter 2014
Emerging market equities outperformed developed market equities, including the U.S., during the quarter. The Fund’s MSCI Emerging Markets Index benchmark gained 6.6%, outperforming the domestic, large-cap oriented Russell 1000 Index and foreign-focused MSCI EAFE Index. The conflict involving Russia and Ukraine calmed during the period providing a boost in sentiment for emerging countries, particularly towards the end of the quarter. Investors had fled Russian equities earlier in the year on worries that trade sanctions against companies doing business with Russia would negatively affect corporate earnings and reduce economic growth. When these sanctions did not materialize to the extent feared, Russian equities rebounded in May and June.
Strong returns in Turkey and India also helped the index as those two countries bounced back following underperformance earlier in the year. Turkish equities had been under pressure on concerns about the strength of its economy and recent political turmoil ahead of its upcoming presidential election. The Turkish central bank lowered interest rates more than expected which provided a boost to equities. The market also responded positively to local election results that showed the opposition party would not be able to gain control, as investors had feared. In India, equities soared following its much-awaited elections in May. Investors are hopeful the new government will be able to grow the economy through tax reforms and infrastructure spending.
In 2013, we saw a huge divergence in the stock market performance of Emerging Markets and the rest of the world. This trend continued at the beginning of this year as macroeconomic and political uncertainty took center stage. It has been a difficult period for our strategy to add value, as the major factor components in our quantitative model have been mixed and volatile. We have continued to pursue our long-term strategy with a focus on stocks that possess both good valuation characteristics as well as a catalyst, such as estimate revisions. Although this combination has not worked particularly well since the beginning of 2013, it has historically been a powerful pairing within Emerging Markets dating back to 2005. During the financial crisis in 2008-2009, centered in Europe and the U.S., stocks with attractive valuation and estimate revision metrics excelled within Emerging Markets.
We think the current Emerging Market environment is similar to what we saw during the financial crisis. Investors seem focused more on macroeconomic events than corporate fundamentals, with performance substantially weaker in the U.S. and developed markets. Now, with the uncertainty centered on Russia and other peripheral countries, performance in Emerging Markets has suffered more than elsewhere.
A bright spot for the strategy is that small-cap Emerging Market stocks with positive valuation and estimate revision characteristics have done well of late, in stark contrast to the weak performance on the large-cap end of the universe. This has helped the Fund given the all-cap nature of our strategy. Although the portion of the portfolio invested in small-caps is considerably less than that of large-caps, this small-cap weighting has bolstered returns somewhat.
Struggling Materials Picks
The Fund lagged its benchmark during the quarter and still trailed for the year-to-date through the end of June, though to a far lesser degree than in 2013. Results for the three primary categories of our quantitative model were mixed, as Market Dynamics and Valuation performed well overall but were volatile from month to month, making it difficult for the strategy to outperform. There was not one individual month during the quarter where all three of our major alpha components were positive. The current environment is consistent with what we have been seeing for the last few quarters—factors to moving in different directions and volatile from month to month. Consequently, it has been difficult to position the portfolio to capture positive relative returns despite our overall alpha model being modestly positive.
Stock selection across sectors was modestly negative during the quarter, with Materials, Financials and Consumer Discretionary the primary detractors. Stock selection was positive in Consumer Staples, but not enough to offset negative stock selection elsewhere. Allocation to sectors was essentially flat with a slight positive from an underweight position in Financials relative to the benchmark. In terms of country attribution, allocation added modestly to performance, led by underweight positions in United Arab Emirates, Qatar, and Greece. Stock selection did not add value primarily due to negative results in Brazil and China, offsetting picks in Mexico and Korea.
Given the pickup in performance of Emerging Markets versus developed and U.S. equities, we are hopeful that cash is starting to flow back into the asset class. As flows increase, we would expect our Valuation factor components to benefit as investors search for cheap stocks that have been beaten down but still retain good growth prospects. Although uncertainty with Russia and the conflict with Ukraine remains, we believe that it is important to balance the portfolio against either an up or down market scenario by having more equal exposures across all of our major factor components. In addition, we have put additional emphasis on risk control to ensure that we do not have any unwanted biases. We believe this approach has allowed us to keep pace with the benchmark this year despite a difficult environment for stock picking. We will continue to monitor where we are in the market cycle by looking at valuation spreads, factor performance, and stock correlations to adjust exposures 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.
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.