3rd Quarter 2013
Emerging Market equities experienced a modest rebound during the quarter as the US Federal Reserve’s announcement that it would keep its current monetary policy in place provided some relief for investors. Despite the September surge, however, the asset class continued to lag U.S. and developed markets, trailing the domestic large-cap oriented Russell 1000 Index by a wide margin year-to-date.
One of the key fears related to the end of low interest rates in the U.S. is that emerging countries will no longer be able to finance the high growth they have experienced in the past. Although the average growth rates for Emerging Markets are still higher than developed markets as a whole, the gap has narrowed substantially from 10 years ago. In 2008, forecasted earnings growth across all the asset classes declined by a magnitude of roughly 30%. Since the financial crisis, forecasted earnings growth rates have bounced back in developed markets to their pre-crisis levels but Emerging Markets have remained depressed. As forecasted earnings growth for developed markets has improved, investor capital has shifted away from Emerging Markets, and performance in those markets has suffered.
The question now is whether the days of high growth are over for Emerging Markets. This is a difficult question to answer with any certainty, but we think there are plenty of opportunities in emerging countries that have substantially higher growth rates than the benchmark average. In fact, the average growth rate for the four largest countries in the Fund’s MSCI Emerging Markets Index benchmark is 15.4% versus an average of 12% for the entire index. In contrast, Japan’s expected growth rate has jumped to 16.0% following years of stagnation, but the average growth rate for Europe is less than 10%. Thus, while it is true that the average forecasted growth for Emerging Markets has come down, there are still opportunities for high earnings growth in several countries.
As we mentioned last quarter, the underperformance of Emerging Markets has also created an opportunity in terms of relative valuation versus other asset classes. As of the end of September, the universe had an average price/earnings ratio of 11 versus 18 for the developed market MSCI EAFE Index and 16 for the Russell 1000. The price/earnings ratios for small-caps in both the U.S. and developed markets are even higher. Thus, at least on this one measure, Emerging Markets are currently cheaper than other asset classes that we monitor.
The Fund lagged the benchmark during the quarter as a strong performance from our Valuation factors were largely offset by weak results from Market Dynamics and Earnings Quality. Within our Valuation metrics, more-defensive factors such as book-to-price and sales-to-price worked better than earnings-to-price or forward earnings-to-price. Defensive Valuation factors typically work best following market crises. Investors look for cheap stocks that have been beaten down but tend to distrust earnings estimates as they wait for markets to stabilize before focusing on company fundamentals again. Consistent with this behavior, Market Dynamic factors such as Earnings Revision and Price Momentum performed poorly. Earnings Quality was a modest negative, largely due to a tough August that offset slightly positive results in July and September.
Stock selection was a net negative this quarter, most notably in the Financials and Technology sectors. Our model did not work in Financials where negative results from Market Dynamics and Quality factors were more pronounced, making it difficult to add value in the sector. Stock selection was superior in Materials. Sector allocation detracted modestly from overall performance, with an overweight in Consumer Staples and an underweight to Energy detracting from returns. In terms of countries, stock selection was negative primarily due to holdings in Taiwan and China. The best stock selection was in South Africa and Chile. Country allocation also detracted from performance, led by an overweight in Turkey and an underweight in China.
Despite the behavior of the factors and the recent positive performance of the asset class, we would not characterize the current environment as a market rebound. Emerging Markets have not experienced big declines year-to-date, they have essentially been flat while developed markets have soared. Valuation spreads, which measure the difference between the cheapest and most expensive stocks in the universe, have been stable since the end of the year. They remain narrower than the long-term average, which would not indicate there is as much opportunity for Valuation to perform strongly on its own. Narrow valuation spreads indicate an environment where a balanced approach between value and momentum is appropriate. Thus, we continue to look for stocks with attractive Valuation metrics and that have a catalyst such as Earnings Revision or Price Momentum.
Strategy and Outlook
Our investment philosophy is based on a bottom-up quantitative approach to investing. We believe inefficiencies in the market create opportunities and a quantitative process is well suited to capture and benefit from these inefficiencies. Our stock selection model groups factors into three major categories—Market Dynamics, Value, and Quality. Market Dynamic factors are designed to exploit short-term trends as investors under- or overreact to short-term news and events. Value factors seek to capture reversion-to-the-mean moves as investors extrapolate long-term trends. Quality factors incorporate information about the quality of earnings that investors tend to overlook. Over time, we believe this style of management will help generate positive relative returns.
We cannot predict whether Emerging Markets will continue to rebound for the remainder of the year, but we are hopeful that the volatility in equity markets will subside and corporate fundamentals will matter. We believe that in the current market environment it is important to balance the portfolio against either an up or down market by having more equal exposures across all of our major factor components. This approach has worked well for our model in the past in weathering periods of higher market volatility. We are monitoring where we are in the market cycle by looking at valuation spreads, factor performance, and stock correlations. After a period of negative results for Earnings Quality at the end of 2012, those factors have been positive this year, on average. We are hopeful that this positive shift will continue and help the portfolio ride out any volatility among our Market Dynamics and Valuation factors.
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.