We recently sat down with Simon Roe from the Active Quantitative Equity (“AQE”) team to talk about the Emerging Markets Enhanced (or “EM Enhanced”) strategy and how it can serve investors. The following is a transcript of that interview, which has been edited and condensed for length and clarity.
The editors: What is the EM Enhanced strategy designed to do?
Simon Roe: EM Enhanced tries to add a really small amount of alpha over and above our benchmark index [MSCI Emerging Markets Standard] consistently through time, with tight active-risk control. We’re not trying to hit the ball out of the park; it’s all about little incremental gains, quarter on quarter, year on year.
How do you accomplish that?
We do it through active stock selection, using our proprietary model. We take very small positions away from the index toward stocks that we like and against stocks we don’t like. We go for stocks that are cheap, have very high quality scores, and are usually liked by the market.
Like other enhanced strategies in AQE, we’re benchmark-neutral from an asset allocation perspective. We match the index on the country, industry, sector and currency positions, which means we can track the index with a reasonable amount of certainty.
Who might benefit from investing in EM Enhanced?
Most of the clients that we see coming to this product are people that would traditionally have had an index position in emerging markets. They’ve decided that it’s worth taking a little bit of extra risk, given the reliability of the extra return, in order to work that core just a little bit harder.
What’s especially compelling right now about the emerging-markets opportunity for equity investors?
I would say since probably around early 2016, we’ve seen a lot of our clients put more money to work in emerging markets — I think because they’re still inexpensive versus developed markets. So we’ve seen our clients putting more money into it, and we’ve seen new clients coming to us as well, especially over the last 5 years. It’s been a good story!
I’m a big believer that emerging markets are very different from developed markets. The inefficiencies in emerging markets provide greater alpha according to our research, and I think this skews the game slightly in favor of active management versus passive management. The potential to find alpha in emerging markets is both greater than in developed markets, and it’s more consistent.
Is this because there’s much less analyst coverage in emerging markets compared with developed markets?
Yes that is one of the reasons — there’s just a lot less attention on emerging market stocks than there are on developed-market stocks. If you just think about the number of analysts that follow Apple versus the number of analysts that follow some small names in some of these emerging markets, there’s less focus on the underlying fundamentals and the underlying companies themselves. That gives rise to pricing inefficiencies.
What other attributes of emerging markets tilt in favor of active management?
Trading costs are significantly higher in emerging markets compared with developed markets, and there’s a lot more index reconstitution in emerging markets than there is in developed markets. Index managers are forced to trade just to keep in line with these changes in the index, and they have to do that in markets that are more expensive to trade.
Because we can take positions that are not at the index — we make some small active bets — we don’t have to buy every stock that, for example, MSCI to China. That gives us flexibility, and we can utilize the capital toward the stocks that we like better.
And because you’re taking positions in 500 to 700 stocks, you’re also able to optimize for transaction costs across many names.
Yes — and especially for very large investors, transaction costs are key. It’s very hard to put billions of dollars to work with highly concentrated managers buying only, say, 50 stocks, because they just can’t take that size of a position easily in the market for that amount of money. Strategies like EM Enhanced have been very useful for these super-large investors, because these strategies put that money to work at scale, across hundreds of stocks. With current liquidity levels, I can easily go in and buy $100 million of this fund in a day. Whereas perhaps you couldn’t do that for some of the more concentrated active funds.
We’ve touched on information deficits in emerging markets. At the same time, accessing quality data inputs for your stock-selection model is so important. How has that played out in emerging markets?
Are you able to access data that you feel confident in?
Obviously, as quantitative investors, we back-test all of our ideas as far as we can, and the available data is actually much better than you would think. It’s fair to say that 20-odd years ago, in the mid- to late-nineties, the data
was pretty sparse. Sell-side analyst forecast data, in particular, was not that available. But it has got a lot better through time. As far as we’re concerned, we have good faith in the underlying data extending back over a decade to when we built this product back in 2007, and it’s getting better.
Even when it comes to our new ESG signal that we’ve added this year to our stock-selection model: emerging-markets companies have ESG scores as well. The ESG-related data in emerging markets only dates back to around 2012 or 2013, which is when ESG-related reporting really started to gain traction in emerging markets, but there is data there.
You’ve actually been involved with this strategy from its inception, right?
Yes, I was part of the initial research team that was doing the research for it back in 2005 to 2006, and I’ve basically been running it since it started back in 2007.
What gave you and the team the idea to start developing the strategy?
The initial idea was actually sparked by one of our clients. Back in 2005, a client came to us with the observation that their index managers tended to trail the index in emerging markets, and asked us to consider applying the
active processes we used in developed markets to emerging markets. And we’d never really thought of that before, because we thought that the data wouldn’t be good enough. Actually we found the data was better than we expected, and we realized that we could build something with the potential to be successful.
The Emerging Markets Enhanced strategy has beat its benchmark 75% of the time on a rolling 3 year basis since inception.*
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