Why active in emerging markets?

Is a passive or active investment strategy the best way to capture growth in emerging markets?

14 May 2018

We feel that the term 'passive' doesn't sit well with emerging markets. That's because another word for 'passive' is static, and emerging markets are anything but. They're changing rapidly, and that's just one of many reasons why we believe it's essential to take an active approach to capture new growth opportunities.

Exploiting inefficiencies

In contrast to many developed markets, emerging markets are largely under-researched as there's fewer research analysts covering these markets. In addition to this, emerging market companies often don't reflect information as efficiently as developed markets as there is generally lower standards of required information disclosure in emerging markets.

With less information available, there's a greater likelihood that share prices don't fully reflect the true value of the companies they represent, thus creating an inefficiency in the market, but also an opportunity.

On-the-ground, in-depth company research is invaluable in obtaining insights into hard-to-research companies and making more precise valuations on potential investment targets than a desk-based researcher.

Looking forward, not back

On the other hand, passive managers follow benchmark indices, but benchmarks look backwards. Index companies build benchmarks on past performance of companies they choose.

And that's a mistake in emerging markets. Why? Because as emerging markets evolve, new sectors are appearing and fresh trends are arising.

That's where active management can make a difference. By using our local knowledge to understand new trends within emerging markets, we can pinpoint companies and sectors that passive strategies and backward-looking benchmarks simply can't.

Grabbing opportunities

Benchmarks tend to be built on a limited number of stocks. Take the MSCI Emerging Markets Index, it is market-cap weighted and limits the number of companies in the index based on minimum trading volumes. That means larger-cap companies dominate the index.

That's a problem for many reasons, but two in particular.

Firstly, because there's a limited range of companies in benchmark indices, passive strategies miss out on opportunities, particularly in the small-cap space where high-potential companies are emerging.

Secondly, larger companies in emerging markets indices are often state-owned, which can mean that they have national obligations that are not necessarily aligned with investors' interests.

Taking an active approach, unconstrained by a benchmark, provides us with the flexibility to invest in a larger range of investment opportunities and provides more potential to realise above benchmark returns.

Catching the wind

Being active also means being sensitive to on-the-ground sentiment, which is especially important in emerging markets where there are a wide range of countries that all have their own political cycles.

From time to time, these cycles and related trends can be misinterpreted by the mainstream media, and profound, long-lasting changes can go unnoticed.

Take demonetisation in India starting in 2016. At the time, mainstream media said it would spark social chaos, destabilise the government and derail much-needed reforms. Because we take an active approach to investment management, we try to understand trends from the ground up, so we went to rural India to meet businessmen, farmers, journalists and local people to hear directly from them.

We found the demonetisation policy had some negative impact, but it had also promoted digitisation, increased oversight of tax evasion and helped implement a goods-service tax - a vital revenue stream for India's government.

More significantly, we found support for the policy among lower-income groups, which made us more confident in future political stability and that the government would pass essential reforms to improve India's economic outlook.

Our on-the-ground approach, which we have repeated in China, Russia and many other emerging markets, means we had an in-depth understanding of the situation and we could confidently take against-consensus positions and create opportunities to beat market benchmarks.

This is a key differentiator between our active approach and passive strategies, which don't offer or incorporate the same granularity of insight into emerging markets, and means we have a better chance of outperforming.

Selecting on sustainability

Our active approach to investment means we build a detailed list of criteria to evaluate companies and environmental, social and governance (ESG) requirements feature prominently.

This is an advantage over passive managers because very few passive emerging markets strategies factor in ESG scores when selecting stocks.

That's where our active strategies are different. Our rigorous company quality checklist features 32 questions, 14 of which are on ESG standards.

By sorting companies according to ESG factors and verifying their credentials with bottom-up research, we're best set to judge how sustainable their business models are and which are poised to emerge as industry leaders over the long-term.

A compelling case for active investment in emerging markets

We're confident in our forward-looking approach, unconstrained by limits on stock selection, supported by far-reaching on-the-ground insight, and managed according to rigorous criteria. With our unique approach, supported by an experienced team embedded in the markets we look at, we believe we're best set to capture the latest emerging markets growth upcycle.

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