1st Quarter 2014
Emerging Market equities retreated in January primarily due to headline risk related to several key markets. In Turkey and South Africa, concerns centered on the strength of their economies given large current account deficits, as investors worried whether they would be able to raise interest rates enough to shore up their currencies without slowing economic growth and increasing inflation. These concerns seemed to abate after both countries did raise rates and stocks subsequently rebounded in February and March. Russia was in the news throughout the quarter as the conflict with the Ukraine over Crimea heated up. Investors shunned Russia on fears the U.S. and Europe would impose trade sanctions if it did not negotiate with Ukraine, with Russian equities falling close to 15% on worries that such sanctions would negatively affect corporate earnings and reduce economic growth. Despite the turmoil, the asset class as a whole managed to retrace much of the downdraft from January to end the quarter down slightly, as evident from the Fund’s MSCI Emerging Markets Index benchmark.
The Fund itself underperformed slightly during the quarter. Earnings Quality was the major factor category in our model that provided the boost, with the Market Dynamics and Valuation factors detracting from performance. Those results were diametrically opposite last quarter’s, and category performance remained volatile from month to month.
Our investment approach is built on a bottom-up quantitative model. We believe inefficiencies in the market create opportunities and a quantitative process is well-suited to capture these inefficiencies and outperform. 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 we believe investors tend to underreact in the short term. Value factors are intended to capture mean reversion as investors tend to overreact in the long term. Finally, Quality factors incorporate information about the quality of earnings that investors tend to overlook.
The negative results for the Market Dynamics category was mainly affected by price momentum. Last quarter, and for much of 2013, investors focused on price momentum in Emerging Markets. Stocks that had good price performance were favored over cheap stocks, which were perceived as more risky in the face of geopolitical and economic concerns. This trend has reversed itself thus far in 2014. Although average results for Valuation were negative overall, results reversed late in the quarter and were positive in March.
The current environment is consistent with what we have been seeing the last few quarters. Results for our three factor categories continued to move in different directions, and were volatile from month to month. Consequently, it has been difficult to position the portfolio to capture any positive trends. There were, however, hopeful signs in mid-March that Valuation was beginning to work consistently, while Quality and estimate revision within Market Dynamics were also modestly positive. Stocks that possessed both good Valuation and estimate revision factors paid off positively. This was a big shift from January and February, when that combination was quite negative. We are hopeful this trend will continue, and look to keep the strategy as balanced as possible across components to capture any potential trends.
Stock selection among sectors was modestly positive during the quarter led by holdings in Financials, Energy, and Industrials. The allocation effect among sectors was essentially flat, with an underweight position in Energy a slight positive. In terms of countries, positive stock selection in Korea and Taiwan was offset by negative results in Brazil and China. Country allocation added to performance, led by underweights in Mexico and China, and an overweight stake in South Africa.
Emerging Markets got off to a rocky start in 2014 as geopolitical risk and macroeconomic uncertainty continued to plague the asset class. Meanwhile, U.S. markets soared to all-time highs. Emerging Market stocks appear cheaper than domestic equities on a price/earnings basis. The question is when investors will start to allocate away from the U.S. and developed markets as valuations become more and more lofty. As investors begin to look past the macro issues affecting some Emerging Markets, we think lower valuations will eventually attract inflows that should help elevate those markets.
Five countries—Brazil, India, Indonesia, Turkey, and South Africa—have elections upcoming in 2014, which could mean several more months of volatile performance as investors await the outcome of those elections and the political environment begins to stabilize. In the current market environment, we think it important to balance the portfolio against either an up- or downswing in the market by having roughly equal exposures across all of our major factor components. This approach has worked well for us in the past during periods of higher market volatility. We continue to monitor where we are in the market cycle by looking at valuation spreads, factor performance, and stock correlations, and adjust the strategy’s 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.