Investors can be a funny breed. One minute, enthusiasm strikes and we collectively want the same thing. Next minute, we avoid it like the plague.
This summarises what has been a fascinating 10-years in financial markets. As investors herd from one view to another, we have witnessed extremes of euphoria and despair.
Beyond being a salient lesson to investors of the powerful impact of behavioural biases on investors, fund flows form two key functions. First, they provide excess returns to valuation-driven investors, as this form of investing is predicated on buying assets that the ‘herd’ has fled and owning them until the herd returns. Second, these flows provide a powerful market awareness tool.
As the great Warren Buffett says, “be fearful when others are greedy and to be greedy only when others are fearful”. The general idea is to do the opposite to the average investor, reversing the ‘investor behaviour gap’ which is known to act as a drag on investor returns.
Fund flows can therefore play a very positive role in the asset allocation process.
The Emerging Market Conundrum
Emerging markets flows region have been extraordinarily resilient. Both emerging market equities and debt have attracted huge sums of money over the past 10 years. The collective sum has now grown to the tune of almost $450 billion, flying directly in the face of other regions that have experienced large outflows.
While this would ordinarily act as a potential contrarian signal, it is worthwhile pondering whether this is cyclical or structural. To our way of thinking, in this case it is a warranted shift by investors as emerging markets offer far better fundamental appeal and continue to do so. Specifically, while other key regions such as the U.S. are priced as much as 33% over their ‘fair value’ relative to earnings, emerging markets are trading far closer to a ‘fair’ level.
It is also worth highlighting the pay-out growth derived from these earnings, as emerging markets have given up 1.8% per year over the past decade whereas the U.S. has grown pay-out growth by 4.4% per year. If one considers this relative to the state of the respective economies, it is not difficult to comprehend the unsustainable nature of the cyclical upswing outside of emerging markets.
This maintains our conviction in emerging markets, especially on a relative basis. Our assessment of the valuation-implied returns, shows a 2.4% per annum premium to the global index. The level of conviction has waned in absolute terms though, as the strong equity rally has pushed the valuation-implied returns for emerging markets down from 5.3% to 4.0% over the past 15 months.
A further element is to question the appropriate sizing of emerging market exposure in portfolios given the current dynamic. This poses its own set of challenges, primarily because a very tight relationship between commodity prices and emerging market equities continues to exist.
Therefore, from a risk perspective it is not good enough to go “all in” on emerging markets just because they have superior fundamentals or valuation-implied returns. One must also be cognisant of their overall portfolio exposure to energy, resources, commodities and how this blends with emerging markets – as investors seek to avoid all their downside risk coming from the same source.
The Lesson for Portfolios
The $450 billion question is whether investors are positioned too aggressively towards emerging markets. We don’t claim to have all the answers and never will. However, it is becoming increasingly clear that many investors are holding a level of emerging market exposure that attributes a large proportion of their portfolio risk and an indirect bet on commodity prices.
From our perspective, this is something we want to be aware but not necessarily scared of. We want to ensure our best ideas are represented in the portfolio but want to equally minimise the permanent loss of capital. It is this fine balance that reiterates the importance of having multiple performance drivers, including a willingness to diversify into uncorrelated opportunities that can smooth the total portfolio outcome.
This requires us to think far more broadly. We need to explore the idiosyncrasies within, including sector exposures and the prospective valuation-implied returns on offer from various parts of the investment universe. In practice, this is a complex exercise, however it provides a much more holistic view of the opportunity set.
